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Beware of Annuities: Inside the Risks and Conflicts of These Retirement Products

Whether you’re nearing retirement or have already begun this chapter in your life, you may be wondering about how to ensure that you’ll have a comfortable income stream and enough savings to last throughout your golden years. While you may be thinking about purchasing annuities to gain this income protection, it’s important to understand that annuities by no means guarantee long-term retirement security.

In fact, annuities can be detrimental to your financial health, as they tend to be riddled with hidden fees, deceptive levels of return, suboptimal tax treatments, and other downsides. While annuities are not inherently a bad choice for achieving guaranteed income, you should carefully examine these investment vehicles before buying one, as they are often sales products designed to benefit those selling annuities more than you.

In this article, we’ll explain how annuities work and the pros and cons of these products. We’ll also examine how selling annuities differs between commission-based financial advisors/insurance agents and fee-only financial planning firms that have a fiduciary duty to offer advice in your best interest.

 

In This Article:

What Is an Annuity?

How Do Annuities Work?

Why Choose Annuities?

What Are the Downsides to Annuities?

What Are the Different Types of Annuities?

Can You Make Changes to an Annuity?

Think Twice Before Purchasing an Annuity

 

What Is an Annuity?

Put simply, annuities are insurance products that turn investments into income streams via an agreed-upon series of payments. In many cases, annuities involve a retiree paying a lump sum of money and receiving guaranteed income for the rest of their life in the form of monthly payments. In other cases, an investor might gradually put money into an annuity during their working years and receive a guaranteed income in retirement.

 

 

How Do Annuities Work?

As described in more detail later in this article, there are several types of annuities, and the differences affect how they work. In general, however, an investor puts a certain amount of money into the product, and that money then belongs to the company providing the annuity. The annuity company can invest the money and pay the investor back through a series of payments.

The total amount of these payments could surpass the initial investment over time. That’s because the annuity company can use the proceeds from investing their customers’ lump sums of money to pay interest for however long the agreements specify, such as for the life of the investor.

 

Why Choose Annuities?

For many people, annuities seem appealing because of the challenge of managing savings in retirement. Regardless of whether you have $200,000 or $2,000,000 saved, it can be difficult to know what to invest in and how much to withdraw each month to support your retirement, without running out of money.

Annuities, on the other hand, essentially manage this challenge for you, by taking your savings and turning them into a reliable income stream. As described below, however, this convenience often comes at a cost.

 

What Are the Downsides to Annuities?

While annuities might seem like great deals, their value often does not hold up upon inspection. Specifically, annuity risks and disadvantages include:

 

  • Forfeiting your principal investment: When you buy an annuity product, that money is essentially no longer yours, and instead, you have to wait for your serialized payments. That means that if you invest $1 million in an annuity and the insurance company providing the annuity goes bankrupt after they’ve repaid you only $10,000, you could be out the rest of the money you paid.

Even if the insurance company remains solvent, it’s important to realize that you no longer have access to your initial investment. You can’t as easily make changes to your investment strategy as you could if you had that money in a retirement or brokerage account.

 

  • Potentially lower rates of return: An annuity might provide an income stream based on, say, a fixed rate of return of 4% for the rest of the investor’s life. Yet that investor might make a 6% annual return by keeping their 401(k) balance invested in stock and bond index funds. Even if that person lives a long time and would receive annuity payments for many years, the additional return from investments through retirement accounts could be greater than the lifetime value of the annuity.

 

  • Commissions: Your insurance agent or financial advisor might say they are fee-based, but that term does not preclude them from receiving a commission from annuity companies when they sell you these products. Nor do these agents need to disclose whether there are better investments for you to consider. Moreover, that commission needs to come from somewhere, and it often means that it cuts into your returns. A fee-only financial advisor or fee-only financial planning firm, however, has a fiduciary duty to recommend only the best investments for you, and they are not allowed to receive commissions from selling products. That means there’s less potential for conflicts of interest.

 

  • Fees: All investments carry fees, but annuity fees can be particularly opaque and expensive. From administrative fees to fees for managing the investments that your lump sum goes into, annuities carry a range of costs that can eat away at your returns potentially more than if you invested in other products such as index funds.

 

  • Inflation: If inflation surpasses the interest rate of your annuity product during your retirement, you could lose money. On the other hand, if you keep your money invested within retirement accounts, you could more easily switch investments to account for inflation. Interest rates, for example, would likely rise during these periods, so you could invest in bonds or CDs that outpace inflation.

 

  • Unfavorable tax treatment: The income you receive from annuities is taxed as ordinary income, rather than the capital gains tax rates you would pay from the proceeds from other investments. As such, you could end up paying more in taxes with annuities, particularly if you’re in a high-income bracket.

 

 

What Are the Different Types of Annuities?

Annuities generally fall into one of two categories that relate to how the payments are calculated, one of two categories regarding when the payments are made, and one of two categories regarding payment duration. These categories are explained below, along with the primary advantage and disadvantage of one category vs. the other within each group.

 

Types of Annuities Regarding How Payments Are Calculated

Type Explanation Primary Advantage Over Another Type of Annuity Primary Disadvantage Over Another Type of Annuity
Fixed Annuities As the name implies, fixed annuities provide fixed payments based on a fixed rate of return. In other words, an initial investment in a fixed annuity product will theoretically be paid back plus interest via recurring payments that are the same from month to month (or whatever the payment period is) because the interest rates are locked in regardless of market changes. Fixed annuities provide guaranteed income with the certainty of payment amounts. The fixed rate of return might be lower than what you could obtain from a variable annuity.
Variable Annuities In contrast to fixed annuities, variable annuities provide returns based on agreed-upon variable conditions, such as the performance of certain mutual funds that the initial lump sum is invested in. As such, payments can vary each period based on investment performance. The rate of return of variable annuities can be higher in the long term than what you would receive from fixed annuities. There’s a lack of certainty regarding income stream, combined with potentially lower returns depending on market conditions.

 

 

Types of Annuities Regarding When Payments Are Made

Type Explanation Primary Advantage Over Another Type of Annuity Primary Disadvantage Over Another Type of Annuity
Deferred Annuities Some people choose to buy annuities long before they need the guaranteed income, and as such, they might choose deferred annuities, where payments are made later than the initial investment. The length of the deferral can be essentially any amount of time, whether it’s one year or 30. Waiting to collect the annuity payments means the investment has more time to mature, which could lead to higher returns. You have to wait to receive your income from the annuity.
Immediate Annuities Annuities do not require a waiting period between the time in which someone invests in these products and the time in which they can start receiving an income stream. As the name implies, immediate annuities can provide payments immediately following an investment in an annuity product, such as to someone who’s already in retirement. You can start to receive payments right away, so you automatically have an income stream. Your rate of return might not be as high it would be if you deferred payments.

 

 

Types of Annuities Regarding Payment Duration

Type Explanation Primary Advantage Over Another Type of Annuity Primary Disadvantage Over Another Type of Annuity
Lifetime Annuities Many people purchase an annuity because they want guaranteed income for the rest of their lives, rather than risk outliving their savings. Thus lifetime annuities can be an attractive option because payments continue for life, even after the initial investment is paid back. You gain guaranteed income for life, regardless of how long you live. You’re locked into the terms of the annuity product for life (other than going through the complex, costly process of ending a contract).
Fixed-Term Annuities Not everyone needs the long-term security of lifetime annuities or wants to commit for that long. Instead, some prefer to receive payments for a specific period and receive their principal back sooner. Fixed-term annuities provide an income stream for a defined period, such as 10 years. You could receive your principal back sooner and re-evaluate what you want to invest in next once the term ends, rather than being locked in for life. You lack the certainty of an income stream for the rest of your life, and by the time your terms ends and you look for a new investment, market conditions may have soured.

 

As you can see, there are several categories to consider when comparing annuities. Not only can it be tricky to decide which annuity, if any, is right for you, but specific products can vary widely, so it’s important to analyze the details of each product individually.

 

 

Can You Make Changes to an Annuity?

Another challenge with annuities is that making changes can be costly and complex. One way to adjust an annuity is to add a rider, which you may be familiar with from other insurance products. Essentially, riders add a layer to your initial insurance policy, thereby amending your coverage.

For example, a living benefit rider can be used to add lifetime guaranteed income to your annuity, but of course, this comes at a cost. Make sure you closely analyze the details of any riders offered to you by those selling annuities and weight those benefits against the cost of putting more money into the product.

In addition to riders, there are also ways to make changes to annuities, including ending the contract before its completion or taking back more of your principal investment faster than the agreed-upon scheduled payments. However, doing so usually carries stiff penalties. For example, if you want to withdraw more per month from your policy than agreed to, you may have to pay what’s known as surrender charges. These fees can vary from product to product and may be based on a percentage of what you withdraw. As such, you would cut into your returns by paying surrender charges.

 

Think Twice Before Purchasing an Annuity

Those looking for income security in retirement may find annuities appealing, but you should be aware of the many risks associated with annuities. Put simply, if a financial advisor or insurance agent tries to sell you an annuity, this may be a red flag, considering how fee-based financial advisors or insurance agents can recommend products that are not in your best interest while they receive a commission.

Always get a second opinion from a financial advisor who does not sell annuities, and if you’ve already purchased one, consider getting a second opinion from an independent investment advisor who can take a big-picture view to managing your finances in retirement.

A good way to gain clarity on this subject is to speak with a fee-only financial advisor rather than a fee-based one. This distinction may seem like semantics, but fee-only advisors are paid by clients, not by investment product companies. Moreover, they have a fiduciary duty to recommend investment products that are in your best interest.

 

Talk with a Fee-Only Financial Advisor

To learn more about your investment options in retirement, including whether annuities are a fit for you, schedule a 30-minute call with us.

At Clayton Wealth Partners, we are fee-only, full-time fiduciaries in Topeka, serving pre-retirees and retirees throughout Kansas, including Lawrence, Garden City, Dodge City, and Hays. We strive to meet your retirement goals through comprehensive financial solutions, including asset management, tax planning, insurance reviews, and estate planning.

 

Schedule a complimentary call today to discuss your situation.

Clayton Wealth Partners

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