According the Secure Retirement Institute, in 2019 Americans bought $241.7 billion worth of annuities. Actually, it would be more correct to say Americans were sold $241.7 billion worth of annuities. It is known in industry circles that annuities are more often sold than bought. This is because they are confusing products that combine both investment and insurance features. And no different than cars or appliances, each product manufacturer has to get innovative to distinguish their product from the competition.
This constant innovation is what leads to ultimate confusion and often poor decision making for investors. Like the refrigerator with a touchscreen computer in the door, consumers can get lost on the features versus understanding what actual benefit they may or may not get from the features. Most folks are looking to spend less time at the refrigerator than more. This same forest for the trees argument can be made about many annuities today.
There are often features that can be added to a vanilla annuity that sound really good when the broker or agent is pitching them. But I have yet to meet an annuity owner who can accurately explain their living benefit two years later. Because they are complex and confusing. And costly – which is causing more and more annuity owners to question whether or not they should keep their old, high-priced contracts at all.
One of the basic benefits annuities provide compared to investing outside of an annuity is income-tax deferral similar to an IRA or 401(k) which can allow the account owner to defer paying income taxes on the growth in an annuity. And some annuities also provide the opportunity for growth in addition to a guaranteed income stream. This can be compelling if your retirement savings may not be significant enough to provide a cushion throughout retirement. But at what cost?
As the saying goes, nothing is free. That is certainly true with investment products of all types and varieties. And while there are many flavors of annuities, we are talking about the category known as a deferred annuity – in contrast to an immediate annuity. A deferred annuity is designed for long-term savings with the intention of deferring any growth or distribution until a later date. Within this type of annuity, the funds could generate returns either through a fixed interest payment, an interest payment tied to a stock or bond market index, or by being directly invested in stock and bond funds.
One of the frequent complaints voiced related to annuities is the high cost. The layering of fees for mortality and expense costs, service fees, investment fees, rider costs, and sometimes enhanced death benefits. When added together, these combined costs can be painfully high and eat into the returns that your investment makes. I have consistently seen annuities where the total costs can run as high as 3.5% per year or more. What that means is if your investments earned 6%, you would actually keep 2.5% after all of the costs are deducted.
Imagine you could reduce the cost by 1% each year. On a $500,000 investment over a 20 year time frame and assuming a 4% annual return, you would have $200,000 more at the end of the 20 years. And unlike market returns that vary from year-to-year, cost reductions are persistent each and every year and accrue to your benefit.
As annuity owners learn about the extensive costs, income tax challenges, and limited guarantees – many are questioning whether or not they should keep the annuity or pull their funds out and invest in a diversified portfolio of mutual funds or ETFs at a potentially much lower cost. If you find yourself asking the same question, here are 4 considerations before pulling the plug.
- Will you owe income tax from built up gains in the annuity? Keep in mind one of the key features of deferred annuities is income-tax deferral on investment gains in the account. If you invested $100,000 in your annuity that is now worth $150,000, you would have to pay income tax on the full $50,000 if you took all your money out. Depending on your other income and tax bracket, this could be a hefty tax bill. The amount of income tax you would have to pay should be compared to how much you would save each year due to reduced costs from investing outside of the annuity. Another consideration would be to take some portion of the annuity over several years to minimize the tax impact.
- Are you or your heirs consistently in a tax bracket higher than the capital gains tax rates? One of the biggest downsides to investing in annuities is that it takes funds that would otherwise be taxed at capital gains rates and causes them to be taxed as “ordinary income”. For income tax purposes there are basically two categories of income: capital gains and ordinary income. Investments not in a retirement account that go up in value are considered to have a capital gain. If the investment has a capital gain and has been held for more than a year, the gain is considered for tax purposes to be a long-term capital gain. This is a positive from an income tax standpoint as capital gains are taxed at lower rates than other income. And if your taxable income falls in the 10% or 12% brackets you currently pay no tax on capital gains. Otherwise, depending on your income you would pay capital gains tax when you sell an investment at either the 15% or 20% rate.
For higher income investors, capital gains rates are preferable to paying tax at “Ordinary income” tax rates that currently go up to 37%. Other income like wages from an employer, pension income or distributions from an IRA are taxed at the higher ordinary income rates. And so are distributions taken from a non-qualified annuity that has gone up in value! Did you catch that? If the gains were earned outside of an annuity, they would be taxed at a lower rate than if they are earned inside the annuity!
And that remains true even after you die. This is huge! If you die with a non-annuity investment the capital gains are wiped out at your death and your heirs would not pay tax on the gains. If you die with an annuity, your heirs will still have to pay income tax on the gains! If your heirs are in a very low tax bracket that may not matter. However, it is often adult children in the peak earning years who inherit annuities so the additional annuity income can push them into an even higher tax bracket. This is something that should be considered when deciding whether to keep an annuity that may not be needed by the current owner.
- What is the cost of having the guarantee versus not having it? Do you know what the costs are in your annuity? And specifically, what is the explicit cost of any rider that guarantees you an income now or in the future? And what are the implicit costs of any limitations or “caps” on the growth in your account? Cost is only an issue in the absence of value. There is nothing wrong with paying extra for something you want. However, it is important to know how much you are paying and to do the math to find out if you will ever really ‘benefit’ from the guarantee offered.
I have seen annuity contracts that offered a guaranteed income for 20 years only after waiting 10 years for the guaranteed value to grow. That is 30 years before you would realize the full benefit. A rational investor should ask whether they will live for that long before deciding to buy such an investment – and potentially pay for the benefit for that long.
- Does the annuity provide you with other non-financial benefits? Up to this point we have only pointed out the left-brained, analytical considerations for having an annuity or not. All things being equal, most investors would prefer lower costs which lead to higher returns and lower taxes – neither of which do deferred annuities offer. However, there are other benefits that are much harder to quantify on a spreadsheet. For example, does knowing that you have a certain amount of guaranteed income allow you to sleep better when the stock market plunges? If this knowledge keeps you from otherwise cashing in investments when they are down, this benefit could far outweigh the higher cost over time. Or perhaps a non-financial spouse doesn’t want to keep up with investments but just wants an income stream without worry. Maybe it is the desire to leave money to a beneficiary who needs protected from themselves in the form of an income, but without involving an outside trustee and this administrative maintenance. The point is there are many intangible benefits that deferred annuities can provide which can be very hard to assign a dollar value to but which have tremendous value to the account owner or beneficiaries. These intangibles must also be considered before dumping your annuity.
While not exhaustive, this list is a good place to start in reviewing whether it makes sense to keep your annuity. It is also important to note that there is a whole new generation of emerging fiduciary friendly annuities hitting the market. As investor preference shifts towards fiduciary advisors who will serve as their advocate without the conflicted advice of high-commission annuities, these lower cost and more transparent annuities are springing up. And due to the lower cost the guarantees are often superior the those offered by their higher commission and less transparent counterparts.
If this topic seems complicated to you, it’s because it is! Like any financial decision, the choice to keep, purchase, or escape from a bad annuity should be made in the context of your goals, financial situation, and longer-term objectives. This is one of many things that a Certified Financial Planner Practitioner™ can help you evaluate. If I can help, give me a call.