Annuities: 10 Things You Should Know

Love ’em or hate ’em, annuities are back. And as always, there's plenty you should know before getting an annuity for yourself.

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Out of favor for a long while, annuities — the controversial and often misunderstood long-term insurance contracts — are getting more attention from investors due to higher interest rates. In 2022, annuity sales crushed the previous record — set way back in 2008, when investors fled to annuities for safety during the financial crisis. Today, some contracts are offering a guaranteed return of over 5% a year. 

“We’ve seen a pretty dramatic increase in annuity receptiveness and sales,” says Matthew DiGangi, head of annuity distribution for MassMutual

Annuities are purchased upfront, often through a single, large, lump-sum payment. The annuity pays a return on the money you put in and when you’re ready, turns the balance into gradual income payments over time that can be guaranteed to last for your lifetime. Sounds simple and uncontroversial, right?

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Yet annuities are hotly debated in the financial community, with some saying they’re a valuable retirement tool while others can’t stand them. Prominent in this camp is investment analyst Ken Fisher, who doesn’t like their fees and returns, compared with other investments. “I’d die and go to hell before selling an annuity,” Fisher declares in his frequent TV commercials. 

If you’re considering buying an annuity, make sure you know what you’re getting into. Contracts can be complicated, and changing your mind after signing up can be costly. And sometimes impossible. 

1. There are many different types of annuities

Single-premium immediate annuities (SPIA) turn your one-time lump sum deposit into future income payments that start right away. Other, so-called “deferred annuities” don’t pay out income immediately and instead grow your savings for the future. At any point, you either start collecting income from the annuity or transfer the balance somewhere else.

A fixed annuity pays a set return, guaranteed by the annuity company. “It’s like a bank CD,” says Paul Tyler of Nassau Financial Group and a host of the That Annuity Show podcast. “The most common terms are between three and seven years.” 

A fixed index annuity bases its return on some market index, such as the S&P 500. It sets limits on your maximum gain and loss. For example, a particular fixed index annuity might make no more than 7% a year when the market is up but wouldn’t lose money during downturns. 

Variable annuities are more like investment products, where you put your money in different subaccounts similar to mutual funds. These annuities don’t offer a guaranteed investment return but might promise a guaranteed minimum income in the future, even if your investment account loses money. How this works though can be quite complicated. “There are so many rules to understand versus a regular investment account,” says Julian Schubach of Wealth Management at ODI Financial in New York City. “Even to advisers, variable annuities can be confusing.”

2. You can have more than one 

If you want a mix of annuity benefits, like one fixed contract for a guaranteed return and a variable annuity for investment upside, Tyler points out that you can buy as many contracts as you want. “You could also dollar cost average out of the market, moving money out of stocks each year to buy multiple small annuities over time. ”

3. Annuities delay taxes 

Annuities delay taxes on your earnings so long as you keep the money in the contract. “There are no capital gains each year, unlike investments [that you sell] in a brokerage account,” says Schubach,

When you start receiving annuity income, you then owe income tax as the money comes out. If you bought the annuity using pre-tax money from a retirement plan, you’d owe tax on 100% of the annuity income. If you bought the annuity with after-tax money, you would receive your contributions back tax-free and owe taxes only on your gains. The annuity company will tell you how much of your income is taxable when you collect payments. 

4. Fees can be high for some products 

SPIAs do not have annual fees because you’re exchanging a lump sum for lifetime income, says MassMutual’s DiGangi. The insurer makes money by investing your deposit to earn more than it pays you in income. DiGangi also says that fixed annuities generally have low annual fees and some contracts even waive them. 

However, fixed index and variable annuities can be expensive. “The fees for the underlying investments tend to be higher than what an investor could get outside an annuity with exchange-traded funds (ETFs) and mutual funds,” says Schubach. There are also fees for the annuity income and performance guarantees. Altogether, DiGangi estimates the annual fees could total 3% to 3.5% of your balance. 

5. Be aware of fat sales commissions

Brokers and insurance salespeople offering annuities can earn extremely high commissions for selling these products. “If someone could make 7% upfront on selling a $1 million annuity, they could be incentivized to make a sale even if it isn’t the best product for a client,” says Schubach, the wealth manager from New York City. While it might involve just a few bad apples, it’s not unusual for annuity companies to face fines due to improper marketing and sales practices for these products. 

Schubach recommends speaking to a few agents or brokers before making a purchase, so you don’t fall for one sales pitch. You could also look for someone working as a fiduciary — including certified financial planners and brokers — which means they must recommend products that put your best interests first, even if another annuity might pay a higher commission. Alternatively, you could hire an adviser who charges for their time and doesn’t earn commissions to compare products for you. 

6. Changing your mind is hard and sometimes impossible 

In exchange for their return and income guarantees, annuities usually require you to lock up your money for years. If you cancel, to move your money out, before you start collecting income from the annuity, you could owe a steep surrender charge. It’s common for annuities to charge 7% of your balance for canceling in the first year, with the penalty gradually reducing over time until it’s gone, perhaps after seven years. 

And once you “annuitize the contract” and start collecting income from an annuity, you’re locked in and usually can’t get your premium back. 

7. But you could get some money out early 

“The majority of products have some free withdrawal policies, where you can get money out with no surrender charge,” says DiGangi. For example, an annuity might let you take out up to 15% of your balance per year without owing a penalty. 

8. Annuities could create an inheritance 

If you set up an annuity with payments for life, you could request a minimum number of years of payments, like 20 years. If you die before 20 years have passed, your heirs receive any remaining payments. 

Increasing the guaranteed number of payments does reduce the monthly income. If your annuity hasn’t started making payments, your heirs could inherit the account value. “Some contracts have an enhanced death benefit. For example, if your contract is worth $100k, your heirs receive $110k,” says Tyler from Nassau Financial Group. 

9. Annuities should be just one part of your retirement portfolio 

DiGangi says don't put all your savings in an annuity, even if the current rates are tempting. “You really want to make sure your liquidity needs are covered outside of the annuity while having a bucket of other investments for growth — 20% to 30% of your savings is a guidepost for how much to put in annuities. ”

10. You already have an annuity through Uncle Sam 

Tyler points out that Social Security operates like an annuity. You pay taxes throughout your career to fund your benefit. When you retire, you receive guaranteed monthly income for the rest of your life, based on how much you paid in. Pensions follow a similar approach.  

Note: This item first appeared in Kiplinger’s Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that’s right on the money.

David Rodeck
Contributing Writer, Kiplinger's Retirement Report