Should you buy an annuity?
Many people mistake annuities for investments but annuities are actually a financial contract in the form of an insurance product between an individual and an insurance company in which the seller (the insurance company) provides a series of future payments in exchange for an immediate lump sum payment or a series of regular payments prior to the paying out of the annuity.
Dennis Miller, in an Investopedia article, wrote that “you are better off with no annuity as opposed to the wrong one.” That isn’t to say that he doesn’t believe they are ever appropriate. Simply put, you shouldn’t buy an annuity unless it will work for you and for many people it isn’t the right tool.
At one time, annuities were sold as a vehicle to make it possible for anyone to have a pension. Annuities can offer a degree of certainty to retirees by paying out a fixed stream of payments over a specified period of time. They were simple enough to make them useful for people who wanted absolutely nothing to do with managing their own finances. According to Fool.com, for those who fear the potential loss of all their money because of poor investments choices, that guarantee can be very important. Other good things about annuities are that there are no heavy record-keeping requirements and there are no investment limits.
- IRAs, 401(k) and other tax deferral plans have been maxed out
- You will keep it for at least 15 to 20 years
- You are in a 28 percent tax bracket or higher today but expect to be in a lower income tax bracket at retirement.
- You need a “guaranteed” income for life in retirement
As a Kiplinger article says, “Seniors are often bombarded with pitches for annuities, and there’s a reason for that: Annuities can be extremely profitable for the agent who sells them.” Over the years, annuities lost their “glow” for a variety of reasons. Chief among them:
- Market performance-You can still lose money according to the Washington State Insurance Commission. Most insurance companies only guarantee you will receive 90 percent of the premiums you paid plus interest at a specified minimum rate. If you didn’t earn enough you could lose some of your paid premium.
- Too expensive-An Investopedia article says that the old joke about annuities is that you make a fortune on the headline and the fine print takes it all back. Introductory rates often act as loss leaders and then when rates are adjusted and the fees kick in all the benefits disappear. Annuities in the past were prone to hidden fees and as a result many states now regulate the percentage of annuities you can hold in your portfolio. The state of Washington has a pamphlet on what you need to know before buying an annuity. You can find that here. Here’s a list of fees you’re likely to run across:
- Commission-People think of annuities as an investment, but they are actually an insurance policy and the nice person selling you the annuity is getting a cut of your return or principle for selling it to you.
- Underwriting-Fees for those who take a risk on the benefits
- Fund management-management fees for any investment in mutual funds
- Penalties-If you pull your contributions out before you are 59 ½, the IRS will get 10 percent and a surrender charge of between 5 percent and 10 percent will be charged. You can transfer your annuity from one insurance company to another but if the check comes to you while in the process of transferring, you could be stuck with fees there as well. Because of surrender charges, any annuity should be considered a long term investment. If you decide to replace your annuity, the agent must provide a notice on the pros and cons of doing so.
- Tax opportunity cost-Your 401(k) is a better option for tax deferral unless you have maxed out your contributions to it. During the accumulation phase, annuities provide a tax advantage however annuity gains are taxed at ordinary tax rates. If your income tax rate will have dropped during the period of time that the annuity is accumulating, you could still come out on top but that’s an individual determination.
- Tax on Beneficiaries-Assets which appreciate over time have what is called a step-up in basis when they are left to beneficiaries. Basically, that assigns a new value to the asset based on the market price at the time of transfer. However, annuities don’t offer the same protection and your beneficiaries are likely to be charged taxes on gains.
- Lack liquidity-If you die, you die but what if instead you live and now you can’t work or you have high medical costs. Now you have a greater need for the money you don’t have access to.
- Lack of security-Annuities were created to provide just that but if the insurance company goes under, your money may be lost. You can check on an insurer’s rating at on the Washington State Insurance Commissioners website to make sure an insurance company has a rating of at least A+.
For those facing the possibility of long-term care and who may eventually have to rely on Medicaid to pay part or all the costs of care, annuities must qualify as Medicaid-friendly in order to generally be counted as income rather than as an asset (assets are subject to spend down for Medicaid). Those qualifications are:
- Income must begin being distributed immediately;
- The annuity contract must be irrevocable and must be set up with a non assignable settlement option;
- The income payout must be constant; and
- The state must be named as beneficiary.
- Limited ability to pass on wealth to heirs-In a report out by the Congressional Budget Office, the authors wrote, “Economic modeling dating back to Yaari (1965) shows that individuals who do not aim to leave bequests to future generations should put all of their investments into annuities rather than alternatives such as bonds.” The paper goes on to say, “This paper models decisions about purchasing annuities in a context where individuals learn new information about their health status over time (that is, with stochastic mortality risk). In that context, the value of an annuity declines when an individual experiences an adverse health shock that lowers her life expectancy. Because of that valuation risk, risk-averse individuals will not want to fully annuitize their investments when they face higher costs or lower income in bad health. We find that most households should not annuitize any wealth. The optimal level of aggregate net annuity holdings is likely even negative.”(emphasis added)
- Investment limitations-According to the Motley Fool, “We strongly believe that Foolish investors can generally do far better for themselves elsewhere.” Actually they call the investment choices “so-so, ho-hum, quasi-mutual fund subaccounts.” A professional money manager can typically charge lower fees than annuities do.
So if you choose not to buy an annuity, what other options do you have?
- Wait on Uncle Sam. If you have other income, it’s best to wait as long as possible to collect on Social Security. Those benefits act as an inflation-adjusted annuity without all the fees. If you think of Social Security as an annuity, says the author of “Should You Buy An Annuity From Social Security?” the increases earned from claiming at a later age are designed to be “actuarially fair” whereas commercial annuities have marketing, management and risk bearing costs that must be added to the actuarial price. Social Security is an attractive option when interest rates have been low as they have been for the past few years, because it is not affected by current interest rates.
- Get professional help. Check out our Preferred Partners list for professionals in the financial industry who understand how financial decisions can impact your eligibility for government benefits.
Other articles on annuities that may be of interest:
The tax implications of an annuity when the trustee dies
This is a good article. We should also note that most people have an annuity already in the form of social security, though the younger you are the less you should count on from it. Also, annuities are expensive right now with interest rates being depressed, and most of them are not indexed to inflation.
– Tom from http://www.lifeant.com/life-insurance-quotes/