Six Mistakes People Make with Annuities
Ask some financial advisors what they think about annuities, and their first thought is likely to be “Commissions.” They won’t say that, of course, but the reality is that annuity sales generate huge revenues for brokers and insurance agents. So it’s no surprise that they sell a lot of them.
But are they good for the rest of us? Under certain circumstances, they can be attractive. For example, a single premium immediate annuity (SPIA) can be a great way to distribute your savings in a stable, predictable manner during your retirement; kind of like your own personal pension. But annuities are generally a lousy way to build wealth due to their complexity and high cost.
Below are six mistakes to avoid when considering purchasing an annuity.
Falling into the tax deferral trap. Tax deferral is one of the most attractive features of annuities. Like individual retirement accounts (“IRAs”) and 401ks, the earnings inside an annuity are not taxed until they’re withdrawn. The problem is that when you take money out, those earnings are taxed as ordinary income. Let’s think about this for a second. If you buy a stock mutual fund outside an annuity, the dividends and appreciation are taxed at favorable tax rates. If you buy that same fund inside an annuity, you won’t pay taxes on the earnings every year. However, when you start taking withdrawals, those earnings are taxed at ordinary income rates. Those rates may be a lot higher than capital gains rates, so over time you may end up paying a lot more taxes.
Failing to add up all the costs. Annuities are complex insurance contracts that can have tons of hidden fees and expenses. Let’s say the mutual fund we discussed earlier has an expense ratio of 0.6 percent. If you buy it from the fund company, that’s your cost. That same fund inside an annuity will have at least that 0.6 percent, but there will also be the annuity’s contract fees, which I’ve seen as high as 2 percent or more. There are also annual administrative fees, rider fees (for additional features), and insurance fees. These fees can take a big bite out of your savings over time.
Putting too much money into annuities. Annuities can play a useful role in distributing your lifetime savings, but they can also be inflexible and very expensive to get out of. I’ve seen annuities with 5-10% surrender penalties for several years after purchase, so if you need the funds you’ve got locked up in an annuity it could be very costly to get those funds back out again.
Swapping out your old annuities for new annuities. The brokers who sell annuities get paid a lot better to sell you a new one than they do to keep you in a contract you’ve had for a while, so they have a strong incentive to convince you to switch. There might be good reasons for it but beware of what you’re giving up. Some older annuities have very high-income guarantees, while newer ones may offer much lower guaranteed values.
Picking the wrong payout. When it’s time to distribute your annuity, you may be presented with options to take a life-only payment (just over your life expectancy) or often a slightly lower amount over a joint life (you and your spouse). You may also be offered a fixed period, like ten years. Most planners will recommend payouts over joint lives, which reduces the risk that one of you dies too early and you lose the annuity income you’ve saved up over the years. This is especially critical if there is a large difference in age between you and your spouse.
Failing to compare different annuities from different providers. Some brokers are only able to sell you financial products from one company. But fixed annuity payouts will vary widely from company to company for the same client and the same starting amount. You should compare quotes for several different products before making your choice.
Annuities are complicated financial products. Before purchasing one, make sure you understand what you are getting into. You may also want to speak with a Certified Financial PlannerTM professional who is not being paid to sell you that annuity to see if it’s really right for your needs and your situation.
This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/investment management and an owner of Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.
Category: feature, Finance, Local News
