Beware of Annuities: 5 Things You Need to Know

By Aimee Calderon, CFP®

As financial advisors in Fullerton, California, we often get questions about annuities. Many of our clients come to us with annuities that they have been sold, or they have questions about an advertisement they have seen about the “guaranteed” income they can receive in retirement.

While not all annuities are bad, most of them are not nearly as great as they look in the advertisements. Following are five factors you need to know when considering an annuity:

1. Fees

Annuities are expensive. The annual fee charged to annuity holders is usually in the range of 2–2.5%.

The fees are so high partly because most annuities pay salespeople high commissions to sell them. Commissions can range between 5 and 7%, which means a $300,000 annuity would pay the salesperson $15,000–$21,000.

These high commissions make annuities very attractive to sell. Therefore, annuity salespeople can be highly persuasive on why an annuity is best for you.

2. Surrender Charges

Since most annuities pay such high commissions, insurance companies need to keep your money in the annuity in order to make money. They do this by attaching surrender charge schedules to your annuity. If you want to get your money out of an annuity before the surrender schedule has ended, you will pay a surrender charge.

Seven-year schedules are typical for surrender charges. Typically, the charge starts at 7% and goes down by 1% every year until you have held the annuity for seven years.

Seven-year schedules may be common; however, I have seen some annuities with surrender schedules of up to 15 years.

3. Tax Deferral

One of the big selling points of annuities is that they are tax deferred. You can put a lump sum of money into an annuity, hopefully watch it grow, and you don’t have to pay taxes until you start taking withdrawals.

Sounds a lot like a retirement account, doesn’t it? So then why are many annuities sold in IRA and 403(b) plans? Do you need a tax-deferred investment inside a tax-deferred account?

As noted earlier, annuities are expensive, so using them for tax deferral inside a retirement account is redundant and unnecessary.

4. Complexity

Trying to read an annuity contract can give you a headache. They are often complex and can overwhelm a typical investor. They are even difficult for financial professionals to understand.

Part of the complexity is from annuities combining investments with insurance. Another reason is that the contracts are written to benefit the company.

Even though annuity ads talk of guaranteed income, high returns, and tax savings, the details of these long contracts show that a buyer can be severely penalized if any misstep is taken.

We think it is wise to keep investments and insurance separate. We recommend that our clients invest their money in pure investments (not insurance) and then insure themselves separately with term life insurance policies.

5. Returns

Advertisements for annuities will often speak of annual returns of 6% or more. This is misleading and not an actual investment rate of return. The 6% promise is a payout rate; it is not an apples-to-apples comparison with an investment rate of return.

If a 65-year old man is offered a $500,000 immediate annuity with a 6.3% “return,” he will receive $2,625 per month for the rest of his life. Assuming a normal life expectancy of 84, the annual investment rate of return for this annuity is equal to 1.9%. If this man lives until age 90, the annual investment rate of return increases to 3.9%.

To get to a 6% annual investment rate of return, the man would need to live until age 116.

What to Do When You’ve Already Bought an Annuity

All five of these points are good to consider before choosing to buy an annuity. But, what should you do if you have already purchased an annuity and now know that it was a mistake?

It’s always good to get the advice of a fee-only financial advisor. As fiduciaries, fee-only financial advisors must put your interests above their own. They can help you read the details of your contract and look at the options available to you to get out of an annuity and move to a better solution. 

Schedule a 15-minute discovery call with a fee-only financial advisor.