What if someone told you that if you gave them a lump sum of money today, they would guarantee you a fixed sum of money every year for the rest of your life? Sounds great right? Unless you only have a couple of years to live. However, with people living longer in their golden years, it could provide some peace of mind knowing that you could never outlive the guaranteed income. It’s not a simple decision. Following are some “buyer beware” concerns you need to know before you purchase an annuity

What is an annuity?
An annuity is an investment vehicle issued by insurance companies that come in two basic types: Immediate and Deferred

An immediate annuity turns a lump sum of money into guaranteed payments immediately after your lump sum purchase. You can opt to receive fixed payments for the rest of your life (lifetime annuity) or for a fixed number of years. How much you receive from a lifetime annuity is based on your life expectancy. The older you are, the higher the payment. The decision to purchase a lifetime immediate annuity is irrevocable after a 30 – 60 day grace period. After that, there is no turning back or getting your lump sum back. Lifetime payments are generally fixed and as time goes on, inflation will definitely eat into its purchasing power.

A deferred annuity is an investment held inside a tax deferred wrapper. Money that you invest in an annuity grows tax deferred until you take withdrawals. When you take withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.

Advantages of an Annuity
The biggest advantage of a deferred annuity is that it allows you to sock away large amounts of cash and defer paying taxes. Other tax deferred retirement accounts such as 401(k)s and IRAs limit the amount you can contribute. This is particularly useful for those who are in high tax brackets now and anticipate being in a much lower tax bracket in retirement. All the money you invest appreciates year after year without any tax bill from the IRS until you withdraw it. That ability to keep every dollar invested working for you can be a big advantage over taxable investments. Deferred annuities also come in two flavors: fixed and variable. A fixed annuity provides a guaranteed rate of return whereas variable annuities are invested in mutual funds (technically subaccounts).

Disadvantages of an annuity
Be aware of the costs and reasons that an annuity might not be the right choice for your situation.

High annual fees: If you invest in a variable annuity you may also encounter high annual expenses.

  • mortality and expense (M&E) charges that are typically 1.25% or more;
  • administrative fees of 0.10%
  • investment management fees ranging from 0.5% to 2%
  • riders that can add another 0.6% to 2%.

It all add ups to 1.85% to 3.85%. That could take a huge bite out of your retirement nest egg and in some cases even cancel out some of the benefits of an annuity. There may be much better investment choices.

Commissions: Annuities are sold by individuals who collect a commission that can be between 3% to as much as 10%. Insurance companies make up for these commissions through higher fees and surrender charges.

Surrender charges: You’re also likely to face a prohibitive surrender charge for pulling money out of a deferred annuity within the first 7 – 10 years (surrender period) after you buy it. The surrender charge typically runs about 7% of your account value if you leave after one year, and generally declines by one percentage point a year until it’s reduced to zero after the surrender period. Note that some annuities come with even heftier surrender charges – up to 20% in the first year. Beware: Some annuities have initial surrender charges that can be as high as 20%. I repeated it so you can absorb the magnitude of surrender charges.

Withdrawals and Taxation: A deferred annuity can be withdrawn as a lump sum or partial withdrawals. The amount that is taxed is based on a last in first out basis. So all earnings or appreciation is taxed first at ordinary income tax rates and then principal can be withdrawn tax free. In addition, withdrawals before the age of 59 ½ are subject to an additional 10% early withdrawal penalty.

Up Front Bonuses: Buyers of annuities are lured by up front bonuses. These bonuses can quickly be offset by high expenses.

Riders: Guaranteed Income Riders and Withdrawal Benefit Riders are fraught with additional fees, exclusions, complicated contract language and often gives the insurance company the right to increase fees and numerous bail outs. I could write a book on the pros and cons, but not today.

Real Life Story

Kathy was approached by an agent who convinced her to put her entire life savings of $800,000 into a variable annuity with a guaranteed withdrawal benefit rider. $600,000 of the $800,000 was an IRA. At 69 she was close to taking her IRS minimum required distributions from her IRA at 70 1/2. There is a 50% IRS penalty if you fail to take your required minimum distributions.

Kathy felt secure with the rider that guaranteed she could withdraw 5% for the rest of her life based on the highest market value of the account. Along with the 8% guaranteed minimum return for the next 5 years her retirement funding was accomplished. Total annual fees for the annuity was 3.5% and her agent was very happy with his $30,000 to $80,000 commission.

What she failed to understand was the 8% guaranteed return stopped when she started her minimum required distributions at age 70 ½, so the 8% return on the IRA was really only guaranteed for 1 ½ years. In addition the highest market value calculation stopped upon the first withdrawal after 1 ½ years. Yet she will continue to pay the 3.5% annuity fee for as long as she holds the annuity.

When Kathy had an unexpected expense of $12,000, she needed to draw additional funds from the non-IRA annuity. Again, there went her 8% guarantee and highest market value on the non-IRA annuity. Additionally withdrawals from the non IRA annuity were taxed on a last in first out basis as ordinary income and were partially subject to a surrender fee of 7%.

Lesson to be learned: “The large print giveth and the fine print taketh away.” Make sure you understand the fine print before you sign the dotted line.


By Sue Brown and Jean Freeman, Brown and Freeman LLC