B&C Financial Advisors Annuity Series – Part 2: Pros & Cons

In the first part of our series on annuities, we defined some common terms associated with these often-complicated insurance products. Now that we are a bit more familiar with the terminology, in this post we will highlight some of the pros and cons of annuities.

(It is important to note, as we continue through this series, our goal with these articles is not necessarily to persuade our readers to purchase an annuity or discourage them from doing so. Rather, we simply hope to educate consumers and encourage further discussion before making what is likely a significant personal financial decision.)

Pros

Below are some of the features of annuities that can make them attractive to potential buyers:

1.  Guaranteed Income for Life: Once an annuity contract is annuitized, the regular payments received by the owner of the contract are guaranteed to continue for at least the rest of their life. With additional features such as a “joint life” designation, the income stream can potentially continue even after the owner has died, though this typically lowers the amount of the regular payments.

2. Deferred Taxation: Similar to a Traditional IRA or 401(k), any growth achieved in an annuity is taxed only upon the withdrawal of funds. However, as we will see below, this can be a potential negative as well.

3. Guaranteed Rate of Return: With fixed annuities, the rate of return is known in advance, and this translates into a steady income stream (as opposed to variable annuities or other investment vehicles in which returns can vary).

4. Death Benefits: Annuities, especially variable annuities, often come with certain death benefits that pay out when the owner of the contract dies.

Cons

The following features are some potential reasons to avoid buying annuities:

1. Complexity: One of the fundamental rules of investing is to not invest in a product you don’t understand, and annuities are no exception. The insurance market has expanded significantly over the past decade with many new, often colorful variations on the annuity. Unfortunately, many of these contracts come with fees and limitations so complex that few investors fully understand exactly what it is they are purchasing.

2. Fees: The various fees associated with annuity contracts make them more expensive than other retirement investments. Many are sold through insurance agents who earn a sizable commission when the contract is sold. Additionally, there are typically other annual expenses, often more than 2%. Finally, any additional features (a.k.a. riders) added onto the contract will incur further fees.

3. Surrendering Principal: One of the biggest drawbacks of annuities is once the decision to “annuitize” (i.e. begin receiving regular payments) is made, the money invested into the product (the principal) is surrendered to the insurance company. This means the contract owner’s heirs will not receive anything if the contract owner dies, even if death occurs immediately after payments begin. In certain contracts, a death benefit or stream of payments may continue after the owner’s death, but this is typically taken into account by the insurance company when the regular payments are calculated.

4. Growth Taxed as Ordinary Income: As noted above, growth in an annuity is tax-deferred, which annuity salespeople often cite as a main selling point. However, when you take withdrawals, any net returns you received are taxed as ordinary income. Depending on your tax bracket, that could be a lot higher than the capital gains tax rate, which can be a much lower 0%, 15%, or 20%.

5. Lack of Liquidity: Most annuities come with a surrender fee, which you are forced to pay if you take a withdrawal within the first few years of your contract (many contracts have surrender fees for 7-10 years).

In our final article in the series, we will look at a live example of an annuity previously purchased by one of our clients (names will be removed to respect the client’s privacy).

The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.

Adam Oerther

Author

Adam Oerther