What you need to know about annuities

Going back to last summer, we’ve had a noticeable uptick in questions about annuities.  Most are coming from prospective or new clients who were sold an annuity by their current or previous advisor.  They want to know if they should keep it or get out.  If you find yourself in the same boat, we can help you explore your options.  (Full disclosure: We don’t sell annuities or any other financial products.)

Annuities are complex products and come in a variety of flavors.  Each one needs to be evaluated on its own basis by an objective party.  Rather than turn this into a dissertation about annuities, here are five quick and digestible nuggets:

  • Annuities are not investments, even though they are marketed that way.  In reality, they are a contract between you and an insurance company.
  • Annuities are sold as “guaranteed income for life.”  They allow you to transfer the risk of running out of money during retirement to an insurance company.  Guarantees can be costly.
  • High ongoing fees and expenses, large upfront commissions to the salesperson, surrender charges for getting out early, and other limitations reduce the actual return you receive.
  • Once you annuitize your contract, your decision becomes final.  If you live longer than expected, you can come out ahead.  If you die prematurely, the insurance company keeps your remaining annuity money.
  • The tax benefits of annuities are often overstated.  There is no point putting an annuity in your IRA, since an IRA already has tax-deferred status.  Additionally, any gains in an annuity are taxed at ordinary income rates, instead of lower capital gains rates.  And when the annuitant dies, variable annuities do not get a step up in basis, meaning a greater tax burden for beneficiaries.

How to be the annuity company

In the past, we’ve talked about how to be the bank.  Banks earn a profit by lending your money out to others at higher rates than they pay you for your deposits.  For example, a bank might loan money at 5% and pay 1% on their deposits.  The 4% difference is their net interest margin.

A similar process happens when you buy an annuity.  The insurance company invests your money in order to gain a return that covers their expenses and desired profit margin, plus what they promised you.  They might guarantee you a 3% return on your annuity, anticipating they can generate 7% returns over time through their investments.

Just about anything an annuity can do, a diversified investment account can do better.  With the latter, the costs will be much lower, the ability to access your money much greater, and your beneficiaries stand to come out ahead as well.  The downside is giving up the guarantee, meaning you accept the market risk instead of the insurance company.

If you have an annuity or are being approached about buying one and would like an independent third party to analyze it for you, we have a licensed insurance consultant on staff and are happy to help.  If an annuity is right for you, there are better ways to buy one than from a commissioned salesperson.

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Since 1995, we have existed for one purpose...to help our clients live the life they’ve always imagined. We are a fee-only registered investment advisor (RIA) and a full-time fiduciary, meaning we fight for your best interests day in and day out. Our approach results in shared success.

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