Pros and Cons of Annuities
Last week, in an effort to answer many of the questions being asked, we sifted through and dissected the basic characteristics of annuities.
This included immediate vs. deferred annuities, fixed vs. variable annuities, and the accumulation and distribution phases of all annuities.
Now that we have this basic understanding, let’s take it a step further and delve into some of the pros and cons of using annuities.
As I stated last week, annuities are not all good or all bad. They’re simply a tool to have in your planning toolbox.
And, like any tool, they can work well in solving specific problems, but never as a one-size-fits-all solution.
- Guaranteed Income for Life: Sounds pretty attractive, doesn’t it? If you annuitize your annuity, you lock in a guaranteed payment for as long as you live if you wish. This can be an extremely attractive feature for some. If you live to be 156, you still receive your monthly check. (This assumes that the health of your insurance company remains sound and they can fulfill that commitment. A rather aggressive assumption.)
- Tax Deferral: All interest and gains inside your annuity grow tax deferred. So, as an example, if you have $500,000 in bank CDs, and you earn 3%, that $15,000 of interest you receive from the bank is subject to ordinary income taxes in the year you receive it. Even if you don’t spend the interest and roll it back into the CD.If the same $500,000 was held in an annuity, your $15,000 of interest (or gain) would not be taxed until you withdraw funds from the annuity. The long term compound interest benefits from this can be substantial because the money that would have gone to pay taxes each year can continue to grow.
- Investment Flexibility: As I mentioned last week, variable annuities allow you to invest in a variety of investment subaccounts which act like mutual funds you would purchase outside of an annuity. This allows you to take advantage of investment diversification and the potential to keep pace with inflation.
- Withdrawal Privileges: Many annuities offer very stringent withdrawal policies, and penalize you for withdrawing your funds during the first six to twelve years (some even longer). Charges for early withdrawal can be as high as 15% of the amount you withdraw. However, some allow you to withdraw all your gains or 10% of the accumulated value in any given year without surrender charges. (Be sure to check the fine print)
- Surrender Charges: As I just alluded to, most annuity companies charge hefty surrender fees if you remove money from the plan during the first six to twelve years. For example, it is not uncommon for a fixed annuity carrier to charge you 9% if you want to remove funds during the first year of your plan. Most “Equity Indexed” annuities, which have been heavily marketed by insurance companies lately, have as long as a 20 year surrender charge period with surrender charges as high as 15%! Because of this, you have to be very careful about your need for the money you’re placing in the annuity.
- Fixed Annuities: Many companies lure customers in with “bonus” interest in the first year. You’ll see ads in the newspapers like this all the time. While the interest rate can be attractive, it’s typically only for one year. After the first year, the interest you receive is based on the performance of the underlying insurance company. If you don’t like the interest they’re paying in year two and beyond, you have no recourse other than to withdraw your money. However, as I stated above, you may very well be subject to a hefty surrender charge.
- Variable Annuity Options: There are two issues I’d like to call your attention to:
- Insurance companies contract with mutual fund firms to provide some of that firm’s funds in their variable annuity contract. While their subaccount “lineup” may be impressive, it’s not locked in place for life. If the subaccounts you really like are removed from the plan, you can only invest in the remaining subaccount options. And, as in the last example, if you don’t like those remaining options, you may have to pay a significant surrender charge to make a change to another plan.
- Cost: Insurance companies who sponsor variable annuities charge fees in order to run the program. This cost typically hovers around 1.50%. In the long run, this is considerable, so you want to be very clear about what your company charges. The good news is that market forces have worked and some companies now offer very attractive plans with significantly lower fees.
- Ordinary Income Tax Rates: As I noted above, one of the attractive features of an annuity is tax deferred growth. However, all gains removed from annuities are taxed at ordinary income tax rates as opposed to capital gains tax rates which are currently much lower. Even if your stock market based subaccount in your variable annuity doubles in price, you don’t pay capital gains tax on that gain. Instead, you pay ordinary income tax rates when you withdraw funds from your plan. If you purchased a mutual fund outside of an annuity, and it doubled in price, you would pay capital gains tax rates on that realized gain (currently 15%).
- Annuitizing: While guaranteed income for life is attractive, it comes with a price tag by the insurance company. If you deposit $500,000 into an annuity and select the single life payout, you receive income payments for as long as you live. However, when you pass away, the insurance keeps the principal, even if that occurs in the first year. As I outlined last week, you may choose to protect your spouse by choosing a period certain or joint and survivor option, by payments still end at the end of the period or at your deaths. This is a critical factor to clearly understand.
While this list is certainly not exhaustive, understanding these points gives you a significant advantage.
Next week, I’m going to give you some examples of situations where an annuity might be useful for you, and some examples where they’re being oversold that you want to avoid.
Committed To Your Relaxing Retirement,
The Retirement Coach
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