An annuity is a way to get a guaranteed stream of income in retirement. But not all annuities are the same, and if you select the wrong one, it may cost more money than it has to.
When it comes to annuities there are lots of things to consider, from the type of annuity to the surrender period. Not to mention the financial health of the insurance company backing the annuity. After all, if the company goes under, so does the money you invested in the annuity.
That’s why it’s so important to do your homework and read the fine print before selecting an annuity.
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“Choosing the wrong annuity can result in high fees, poor returns and limited liquidity,” says Ken Nuss, founder and CEO of AnnuityAdvantage, an online provider of fixed-rate, fixed-indexed, and lifetime income.
“For example, if you purchase an annuity with excessive fees or a long surrender period, you may lose a significant portion of your investment if you need to withdraw early," he said.
To assist you in your decision making, here's a look at five common mistakes investors make when shopping for an annuity and how to avoid them.
1. Choosing the wrong type of annuity
There is no one-size-fits-all annuity on the market, although Nuss says some are presented that way. In reality there are different types of annuities that accomplish different goals depending on what you are aiming to achieve. Choose the wrong one and you may not accomplish your income generating goal. The most common types of annuities include:
-Fixed annuity: Payments are made monthly for the same amount. With a fixed annuity you know exactly how much you’ll receive monthly.
-Variable annuity: The payouts are tied to the rise and fall of the underlying investment.
-Indexed annuity: The payouts are tied to the performance of an index such as the S&P 500.
-Immediate annuity: With this type of annuity you typically purchase it with a lump sum and then begin receiving payments within 12 months or less. An immediate annuity can be fixed or variable.
-Income for life annuity: Payouts are for life no matter what age you live to. The size of the payments depend on the account size and the life expectancy of the person holding the annuity. This type of annuity can be fixed or variable.
2. Glossing over total cost details
Fees can eat away at your returns and that is true of annuities. Different annuities have different fee structures and if you aren’t aware of how they add up or impact the performance, you may be in for an unwelcome surprise with little recourse.
Sure there is the free look period or the window in which annuity holders can cancel the contract, but after that you’ll face penalties. Typically the free look period is between ten and thirty days.
There is a 1035 exchange, which allows you to transfer your annuity into a different one without tax consequence, but you could still face surrender charges.
“Each annuity exchange must be analyzed individually for suitability and to determine if it is ultimately in the client’s best interest, particularly if the existing annuity is still subject to surrender penalties,” says Nuss.
Some of the fees to keep in mind when shopping for an annuity include:
-Commissions: This is the fee that goes to the agent you work with to purchase an annuity. The commission varies based on the type of annuity and the complexity of it. The more complex, the higher the commission will be. It can range from 1% to 8%, according to Annuity.org.
-Administrative fees: These are the fees that go to cover the cost of managing the annuity, recordkeeping and process transactions in addition to other administrative costs. This fee is typically under 0.3% of the value of the annuity each year.
-Surrender charge: A penalty that’s deducted from the account value if money is withdrawn from the annuity prematurely. The surrender charge can vary based on the insurance company, the age of the annuity and amount withdrawn.
-Rider: These are additional benefits you can add to your annuity for a fee. Common types of annuity riders include living benefits and death benefits.
3. Shopping on rate or performance alone
Performance and rates do matter, but shouldn't automatically rule out a specific annuity provider. After all you may get a cheaper rate or a higher payout on one annuity but the quality of the insurance provider may be questionable.
Plus you may end up with a product that is harder to understand or contains higher internal fees that aren’t transparent.
“It is vital to evaluate the annuity carrier for their financial stability and client service,” says Stephen Kates, principal financial analyst at Annuity.org.
The Federal Deposit Insurance Corp. doesn’t cover annuities like bank deposits, but they are backed by insurance guaranty associations that protect insurance policyholders and their beneficiaries if the insurance company becomes insolvent and can no longer meet its obligations. Every state, including the District of Columbia and Puerto Rico, has a state insurance guaranty association.
When selecting an annuity, brokers typically look at how long the insurance company has been in business, its balance sheet and its rating from the three rating agencies AM Best, Moody’s and Standard & Poor’s.
4. Overlooking surrender periods and liquidity provisions
Depending on the annuity you select, you could face long surrender periods where withdrawing money early could result in penalties. If you don’t check these details before purchasing an annuity you could end up in a situation where you can’t access the money when you need it.
“Liquidity cannot be overvalued, and locking up your money into a single growth strategy for 10+ years should be considered carefully,” says Kates. Going with a long surrender period also limits your flexibility. “Over a decade-long surrender period, circumstances may change, or opportunities may arise which could change how you view the utility of your products,” says Kates.
Another thing to consider: built-in liquidity provision. They may or may not allow for penalty free withdrawals of interest earnings or a percentage of the contract value annually, says Nuss.
5. Blindly trusting the insurance producer or financial advisor
While recommendations are nice, that doesn’t mean you shouldn’t do your homework on your own before deciding on an annuity. The internet can help. There are online tools available to narrow down your annuity choices.
“Comparison and research are important. Without knowing what you want, it can be hard to find the right product,” says Kates.
“Consider multiple products from different carriers to gain a good perspective on what is available in the market as a solution for your particular goals. If you are working with an agent, understand how that impacts the products you see. Some agents only sell one carrier's products, while other agents sell multiple carriers' products.”
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