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Life Insurance & Annuities Center

The Downside of Annuities

There are some ultra-conservative investors out there who look for the safest, most secure investment possible. When interest rates are low and stock performance is volatile, some investors will look for the opportunity to get the best bang for their buck. For those approaching retirement, it is especially difficult to stomach the volatility of some investments when a steady, substantial and secure income is necessary. To combat these investment uncertainties, some individuals look at annuity plans as a place to secure a nice return on their retirement nest egg. Though these annuity plans draw you in with catchy rates and the promise of monthly income, don’t be fooled: these plans are not without their downsides.

What Is an Annuity?

Annuities are a financial product sold by financial institutions (usually insurance companies) that are used as a way to grow funds to pay out a stream of income over a certain period of time. Annuities are typically used by individuals seeking a means to receive steady cash flow into retirement.

In simple terms, you buy an annuity plan with one large payment or series of contributions. From there, the financial institution distributes money back to you for a certain time frame, depending on what kind of annuity you purchase. The money you put in grows through various investments made by the financial institution. There are immediate annuities, meaning you would get your monthly payments immediately, as well as deferred annuities where the principal is held for a certain period of time before being distributed back to you. There are also fixed and variable rate annuities. Fixed rate annuities guarantee a certain payment that does not fluctuate, while variable rate annuities’ income payout depends on the underlying investment performance.

There are pros and cons of annuities. After all, who wouldn’t like guaranteed monthly income in their retirement years? However, investors should realize that there are other options out there.

Types of Annuities

There are two types of annuities: immediate and deferred. If you invest in an immediate annuity, you will receive payments right away. A deferred annuity will collect your invested money until you are ready to receive payments. Investors have the option of switching a deferred annuity to an immediate annuity at any time.

In both of these categories, annuities can be either fixed or variable.

  • Variable – Investors can choose annuities based on risk level. Payouts are based on the investment’s performance.
  • Fixed – Investors are guaranteed their original investment as well as earnings. The payout amount remains constant for the term of the annuity contract.
  • Fixed Indexed – Annuity payouts are based on the performance of a specified equity-based index.

The Disadvantages of Annuities

Before buying an annuity you should realize that the insurance salesman or financial advisor you are working with is most likely looking out for his or her best interest, not yours; they are trying to sell you this product so they get their commission. So, be wary before making any decisions on a plan that might seem great on the surface, because they might really be a way to entice you to buy the annuity.

Misleading High Yield Rates
One such trap is an initial teaser rate that promises a high-yield rate, when that rate only lasts for a year or so. This plan tries to get you to buy an expensive, long-term plan with the illusion of a high-yield for the duration of the plan, but in reality the returns fluctuate based on market performance after the first year.

Fees and Penalties
Annuities can come with various fees and penalties that you would not have to deal with in other investment opportunities. You can end up paying a lot in just fees for the commission, investment management and insurance.

Early Withdrawal Fees
The plans make it hard for you to take money out of the annuity, say in the case of an emergency, charging a penalty of anywhere between 5% to 20%. This is similar to IRA accounts in the sense that there is a penalty if the investor withdraws from the account before the age of 59 and a half.

Difficulty of Passing On
In the unfortunate event that you pass away, it is harder to pass on the benefits of an annuity to someone close to you. There are certain annuity plans that allow the payments to keep coming to a spouse or other family member in an unforeseen death occurs, but usually these plans are more expensive with lower monthly payouts.

Financial Risks
Buying an annuity plan means that you are putting a lot of faith in the insurance company’s financial health. It is basically a bet that the firm won’t go under; this is especially worrisome if your annuity plan is over a long period of time, as many are. As the struggles and downfall of financial institutions like Bear Sterns and Lehman Brothers show, even once powerful institutions can succumb to poor management and risky business practices. There is no guarantee that your annuity plan won’t go under with another firm.

Opportunity Costs
It seems that with annuity plans you are paying a lot with the hopes of reduced risk and guaranteed income. However, there is no such thing as a free lunch. Annuities tie money up in a long-term investment plan that has poor liquidity and does not allow you to take advantage of better investment opportunities if interest rates increase or if the markets are on the rise. The opportunity cost of putting most of a retirement nest egg into an annuity is just too great.

Taxes, Taxes, Taxes
Annuities may appear attractive as first when it comes to taxes. It is likely than an investment advisor will focus on the tax deferral, but it is not as favorable as you may think.

Annuities use the Last-in-First-Out method with taxes. Ultimately, this means that your gains will be taxed at your ordinary tax rate.

Below are the 2014 tax brackets for income tax according to Bankrate. Investors paying ordinary tax rates will be obligated to pay the tax rate for their regular income listed below.

For more information on income taxes, check out Introduction To Income Taxes.

The Bottom Line

Overall, annuities do offer some positive diversification benefits to an investor who is concerned about their income situation in retirement years. Though annuities have many downsides and are not without their share of volatility, they can add some supplemental income in a relatively safe investment opportunity. However, annuities are not necessarily the best investment option to play it safe. Investing in high quality dividend paying stocks enables you to get impressive dividend payouts and the opportunity for share price appreciation over time, resulting in greater returns than annuities could ever do alone.

If you’re getting close to retirement, you’ll want to make sure you can afford it; find out how to make it more affordable in How to Reduce Your Retirement Costs.