The Top 5 Reasons to Say NO to an Annuity (and One Reason to Say Yes)

| September 07, 2016

Chances are you’ve been approached by a financial advisor at some point in your life trying to sell you an annuity. His or her pitch sounded great, but the thing is this: as great as it sounded, you still felt a little uneasy about actually signing up for one, and you weren’t exactly sure why. Well, here you go – now you know:

  • Limited Investment Options – Annuities, by-and-large, have very few investment options. Most annuities have between 25-50 different investment options and are often proprietary to the company selling you the annuity. Still, it doesn’t seem that bad – that is until you know that there are over 9,000 different mutual funds within the U.S.
  • Fees/Surrender Charges – Generally speaking, there are four types of fees you may pay when you own an annuity, which can cost an investor upwards of 4% per year. Expenses eat away at investment returns, especially when compounded over time. Couple high expenses with limited investment options and you have a recipe for very mediocre returns.
  • Taxes – Let’s get something out of the way right away: there’s no such thing as double tax-deferral and therefore there is no tax advantage for putting IRA dollars into an annuity. However, for those non-IRA dollars, does deferring the tax on capital gains make sense? Well, it depends: would you rather pay higher or lower taxes? A loaded answer to be sure, but the reality is this: in almost every situation, capital gains taxes are lower than income taxes. With annuities, you pay income tax on the gain, not capital gains tax. If you’d rather pay capital gains tax, then scrap the annuity.
  • Potentially higher taxes to beneficiaries – Annuities are a notoriously inefficient way to pass on wealth to beneficiaries. Why? The cost basis of an annuity doesn’t step-up upon the death of the owner of the annuity. This means the beneficiary inherits the annuity with whatever imbedded gains are inside the annuity. When the beneficiary goes to sell some or all of the annuity, that gain is taxed as ordinary income. With certain exceptions, if a taxable investment (ie. investment held in an after-tax brokerage account) passes to a beneficiary upon death, the cost basis steps-up to the value as of the date of death, potentially eliminating any income tax or capital gains tax on the investment. So again I ask, do you prefer to pay more taxes, or less?
  • Too complex – Some annuities are sold to consumers with the promise to capture some/all of the upside of the market with little/no risk on the downside. Sound compelling? Sure, but these types of annuities tend not to perform the way that investors expect because of the complexity of the terms of the annuity: Is the benefit base the same as the current value? What is the participation rate on the upside? Is it daily or monthly participation? Is there a limit on the participation? If the market goes down, can I get my original investment out without annuitizing? If annuitized, is the calculation based on the value or the benefit base? How do I know what the annuitization rates are going to be in the future? These types of annuities are so complex, and so misused by commission-based financial advisors that FINRA issued an investor alert to investors about these types of annuities.

And finally, here’s ONE reason to say yes to an annuity: 

  • You want and/or need a guaranteed source of income in retirement. If that’s what you’re looking for, keep it simple and look for annuities from reputable firms where the terms are straightforward: you give a certain amount of your nest-egg to a financially strong insurance company and they pay you a guaranteed income for the rest of your life. Nevertheless, remember that all annuity payment guarantees are subject to the claims-paying ability of the issuing company.

One of the hardest parts about sorting through annuity options is not knowing the motivations of the advisor selling the annuity to you – is it a 3% commission or a 7% commission?  Before making any decisions, seek out a fee-only financial advisor to get unbiased advice as it relates to your retirement income decisions.

About the author:   Paul Wilson, a 15-year industry veteran, is a Financial Advisor at SDW Investment Advisors, a Minneapolis-based Fee-Only Registered Investment Advisor. Paul writes and speaks on issues related to the high-net worth community as well as a wide range of financial planning topics, with a focus on investor advocacy.  You can follow him on Twitter: @Wilson_Advisor or on LinkedIn.