Annuities: The Good, the Bad, and the Ugly

Retirement security.

That’s all you're looking for, right?

While pensions still exist for some retirees, a guaranteed stream of income from an employer that lasts the rest of your life, unfortunately, doesn’t play into the equation for most people these days.

We understand how this loss of certainty can be unsettling. Unnerving. You might even begin thinking you need some sort of pension-like retirement product to protect your money.

Something, for instance, such as an annuity.

But as you plan for the future, be careful about giving in to these thoughts. Let’s first explain what an annuity is, then we’ll explore why they’re not the ‘no-brainer’ many would like you to believe.

What is an annuity? 

First, it’s important to understand that an annuity is not an ‘investment.’ It is an insurance product.

No one ‘buys’ an annuity. It is a product that’s sold to you. 

At its core, an annuity is a contract between you and an insurance company. In exchange for a lump sum payment (or series of payments), you receive a regular stream of income. This can happen either immediately or at some point down the road (known as a ‘deferred annuity’).

Annuities generally come with a surrender fee as well, meaning if you want access to your own money, it will cost you: a typical surrender fee starts out around 7% in the first year.^[i]

And unfortunately, over the years, annuities have become increasingly complex. Thanks to new marketing tactics, these products that were once fairly consumer-friendly are now being touted as ‘new and improved’ – even though many are anything but.  

The good 

For argument’s sake, let’s say an annuity makes sense for your situation. Is there such a thing as a 'good' annuity?

In theory, yes.

The best type is one that meets a couple of important criteria: it’s offered by one of the highest-rated insurance companies and it’s the simplest to understand with the fewest ‘moving parts,’ meaning it should be ‘fixed,’ have a relatively short surrender charge period, and come with a commission toward the lower-end of the industry scale (1-3%).

But these days, finding such a high-quality, simple annuity product like this can be a challenge. And just because it’s easy-to-understand still doesn’t mean it’s appropriate for you.

Even worse? You could be sold a fixed annuity ‘lookalike’ – a complicated indexed or variable annuity product with expensive riders promising guaranteed future income. Which brings us to… 

The bad

An indexed annuity is linked to a stock index, typically the S&P 500 or an international index, and promoted as a way to protect your money from loss of principal.

However, indexed annuities generally offer lower returns than investment products, they’re illiquid (potentially locking your money up for years, if not decades) with high surrender fees, and there are a lot of internal moving parts that are not only confusing – but not always guaranteed.

It can also be difficult to receive a monthly or annual income with an indexed annuity.

The (really) ugly

A variable annuity comes with even more bells, whistles, and complexities than an indexed annuity. Your money is placed in various investment funds, called ‘subaccounts,’ within the annuity. There is no so-called ‘downside protection.’

Variable annuities can come with annual fees around 3-4%, as well as a longer-than-average surrender period (potentially up to 15 years).^[ii]

And, keep in mind, since there is no ‘stepped-up’ tax basis for annuities invested in equities, a variable annuity is a terrible way to pass on your money to heirs.

As for commissions to the salesperson, you guessed it: the more complicated an annuity, the higher the commission. This would explain why the majority of annuities sold every year are variable or indexed annuities, with commissions to the agent ranging anywhere from 4-8% (and sometimes even higher).^[iii]

No matter what the salesperson may tell you (such as, “I never charge a fee.”), you are paying that person, one way or another. 

What to ask 

If a salesperson or financial advisor ever tries to sell you an annuity, we recommend asking a few pointed questions before signing on the dotted line:

• How do you get paid?
• What are your exact commissions on this product?
• What are the management fees?
• How long will my money be tied up?
• What’s the surrender penalty if I cash-in early?
• Will you receive any perks or bonuses for selling this to me?

And it doesn’t stop there. You should even ask yourself some questions as well:

• What am I trying to accomplish with my money?
• Is an annuity the only way to achieve this?
• Have I compared the pros and cons of other investment options?
• Do I know how to unwind this and get my money back? 

At the end of the day, there are a few, very specific circumstances in which an annuity can make sense for someone. Despite what you may hear in commercials or read online, they’re definitely not suitable for everyone who’s entering retirement or already in retirement.

Educating yourself and knowing the right questions to ask is key.

A fiduciary financial advisor – that is, someone who’s legally obligated to always work in your best interest – can help you determine if incorporating an annuity into your retirement plan is appropriate for your financial objectives.

[i] https://www.iii.org/article/what-are-surrender-fees

[ii] https://www.forbes.com/sites/feeonlyplanner/2015/07/15/annuities-the-good-the-bad-and-the-ugly/#4f5a37887990

[iii] https://www.thebalance.com/what-levels-of-commission-do-agents-earn-on-annuities-146003