Some financial advisors assert that annuities are expensive, contrived insurance/investment combinations promoted by brokers who, according to The Motley Fool, “are getting rich with big commissions.” The site continues to bluntly state that “investors can generally do far better for themselves elsewhere.”
Suze Orman, financial advisor and television host, says that “not very many of us should be investing in annuities at all,” and that “there are reasons why they sometimes make sense, but there are even more reasons why they mostly do not.” However, even the most critical do recognize that annuities provide real benefits for some investors with unique needs.
If you are presently considering the purchase of an annuity, ask yourself the following questions. And keep in mind that like other retirement accounts, funds withdrawn from an annuity before you turn 59 1/2 years of age are subject to a 10% early withdrawal penalty, in addition to income tax on the amount withdrawn.
Questions to Ask Yourself Before Investing in Annuities
1. Are You Accumulating or Distributing Assets?
Many people accumulate investments during their working years to ensure that they will have income once they stop receiving paychecks. If your retirement is more than five years in the future, it is unlikely that annuities will grow as fast as other investment vehicles such as common stocks, mutual funds, or exchange traded funds (ETFs). If you are concerned about the safety of your investments, a portfolio of diversified, high-quality (AAA) corporate bonds is likely to pay a higher interest rate than any fixed-rate or even equity-indexed annuity from a AAA-ranked insurer.
2. How Long Is the Surrender Period?
While most annuities allow you to withdraw a limited amount of funds each year without penalties (the maximum amount of withdrawal is stated in the contract), any withdrawals in excess of the maximum limit are subject to a surrender charge. Age is not a factor in the surrender charge; the fee will be imposed whether you are 25 or 65.
The insurer imposes a surrender fee in order to protect against “runs” on the investment pool. Typically, the fee declines each year the annuity is held. For example, excess withdrawals may be subject to 10% surrender fee the first year after investment, a 9% surrender fee during the second year, an 8% fee in third year, and so on until the surrender fee disappears.
If you are retired (or are nearing retirement) and do not anticipate having to make excessive withdrawals during the period that the surrender fee applies, you should consider an annuity, especially if you are worried about running out of income during your lifetime. According to MarketWatch, Scott Whyte, a financial advisor with Bloom Asset management Inc. in Farmington Hills, Michigan, recommends annuities in those circumstances: “You can help that person get a larger guaranteed monthly income for the rest of their life and therefore have a little less reliance on the variability of the market.”
Many insurers provide a variety of payment options including a fixed period of years, for a lifetime, or even a combination where survivors are guaranteed a benefit. Be sure to seek competent advice before making a decision about payment options, as changing your mind can be very expensive.
3. Are You Using All of the Retirement Tax Benefits Available to You?
Federal tax laws provide ample opportunity for most people to deduct money saved for retirement and let the earnings accumulate tax-deferred until used. Individual retirement accounts (IRAs), including Roth IRAs, are available to most everyone (even those covered by retirement plans at work), and many people are covered by 401ks at work.
The advantage of these plans over annuities is that you can either deduct contributions from your current income or you can take withdrawals tax-free when you retire, depending on the plan, and you don’t pay tax while gains are in the account. However, annuities only provide tax-deferred growth – you must pay taxes on contributions and withdrawals. Therefore, investing in an annuity before taking full advantage of qualified retirement accounts available to you is not recommended – annuities generally make the most sense for those who do not qualify for a traditional or Roth plan.
Financial advisors further recommend not to purchase an annuity within a retirement account before retirement due to its excessive cost when compared to other investment alternatives, limitations on investments, and the duplication of tax benefits.
On the other hand, annuities can be a worthwhile investment if you:
- Have contributed the maximum to all available retirement accounts
- Will pay taxes at the upper rates for the next 10 to 20 years before retirement
- Do not intend to make withdrawals before age 59 1/2
4. Do You Manage Your Own Investments or Rely on Professional Managers?
If you are in the accumulation phase of your life and have the expertise, time, and interest to manage your own investments, there are other vehicles with higher profit potential than the return offered by annuities. And if you prefer that others manage your investments, there are better options:
- Maintaining a Balanced Portfolio of ETFs. Combining an index fund such as the (SPDR S&P 500) reflecting the general U.S. economy with an investment-grade bond fund and a money market fund can provide a level of safety, as well as the higher returns associated with equities at a low cost and minimal research.
- Utilizing Professionally Managed Mutual Funds. While more expensive than managing your money personally, this option provides you with peace of mind knowing that your assets are being tended by professionals who work 24/7 to provide superior results. Mutual funds are available in all categories, from aggressive growth to safety and income. In addition, many management companies offer a variety of funds with different investment objectives, so transferring or balancing your total portfolio can be accomplished inexpensively and easily.
Some annuities offer an equity index feature (returns increase based upon the performance of a selected equity index with a minimum return guaranteed). However, the net return over the long-term is likely to be less than you would receive directly in an index fund. A type of annuity called a variable annuity allows investments in sub-accounts, which are mutual fund-like alternatives.
5. What Is Your Tax Bracket Today, and What Do You Expect It to Be Upon Retirement?
Income taxes are unfortunately an important factor of investment decisions. Many people gradually increase their income during their working years, peaking at or within five years of retirement, and pay increasing amounts of income tax annually as a result.
At retirement, taxable income usually falls as well as income tax liability. Deferring income from high tax years to low tax years is one of the most sensible and utilized tax planning tools. This is the single greatest reason that you should fully contribute to all possible tax-favored retirement accounts before considering an annuity.
While the money invested in an annuity is not deductible, the earnings are tax-deferred until withdrawn in a lump sum or in a series of payments. In the case of a lump sum, the difference between the proceeds and your investment will be taxed at regular income rates. If you receive a series of payments, a portion of each payment is considered principal and is not taxed with the remaining portion, which is considered earned income and is taxed at regular rates. If your retirement income will be taxed substantially below your current rate, investing in an annuity – after you have made all possible tax-deductible investments – can make financial sense.
However, there is one drawback to this strategy for certain high tax-bracket investors whose rate will not significantly decline after retirement: While dividends and interest of capital assets are taxed at regular rates, profits in an asset are subject to a capital gain rate upon sale, the rate depending upon the period of ownership.
If you typically hold investments for one year or more – qualifying for a long-term capital gain – and your income tax bracket will not change significantly after retirement, investment in an annuity may be counterproductive, actually exposing you to a higher income tax rate. For example, if you are in the highest tax bracket, a long-term capital gain is taxed at 23.8%, including the new investment income tax for high earners. Gains in an annuity – treated and taxed as ordinary income – are taxed at the 39.6% bracket for the highest income earners.
6. What Will Be Your Responsibilities and Desires at Death?
The single greatest advantage of an annuity is the flexibility of the payment stream. Since it is a contractual arrangement between two parties, the distribution or payment choices are almost unlimited.
Generally, the decision about your payout option should be deferred until retirement, since your typical payout options include:
- Life Only. You are guaranteed income as long as you live, the amount of each payment based upon your life expectancy. There is no guarantee that you will receive payments for the amount you’ve accumulated, but you may receive considerably more if you live a long time.
- Guaranteed Term. An income stream for life with a minimum number of payments guaranteed, this option protects your beneficiaries if you die prematurely. For example, if you had a guaranteed term of 10 years and died in the sixth year, your estate or beneficiaries would receive payments for the rest of the 10-year term.
- Joint and Survivor Life. You or your survivor will receive an income for as long as either of you live. This option is especially popular with married couples.
- Fixed Period. Payments will be made over a defined period (10, 15, 20 years) to you or your beneficiaries for the full term. In this case, you can outlive your payments.
- Fixed Amount. You decide how much you want to receive each month; the payments stop when the account runs out of funds.
- Lump Sum. This allows you to take all of your accumulated value in a single lump sum, which defeats the purpose of the annuity and is not generally recommended. You will have to pay regular income tax on the entire investment-gain portion of your account.
Most insurers offer an option where the company will pay a death benefit to your beneficiary if you die before distribution starts. The benefit is typically the greater of the contract value or the total premiums you’ve paid.
7. What Is the Financial Strength of the Annuity Provider?
An annuity is as safe as the company that issues them, and they are typically issued by an insurance company. While annuities have generally been considered safe investments, there are cases where an insurance company has failed and the state guaranty association has lacked the funds to provide full payments to all annuitants. Typically, the maximum guarantee of the guaranty association is limited to $500,000 or less. As a result, you should limit your annuity purchases to those companies ranked highest by third-party, independent rating organizations (A.M.Best, Moody’s, S&P, and Fitch) which monitor insurance companies and report on their strength. You should also consider spreading your investment among several annuity providers to provide another level of safety by diversification.
Annuities are complex, long-term financial arrangements which should not be entered into lightly. The classic investment advice “investigate before you invest” is particularly applicable when considering annuities. Be sure you understand the legal and financial terms common to annuities, the way annuities work including popular variable annuities, and seek several quotes from insurers to ensure that you get exactly what you expect.
What other tips can you suggest to invest in annuities?