According to LIMRA, the insurance association trade group, annuity sales totaled over $310 billion in 2022, up 22% from the prior year. Annuities cover a broad universe of financial products, can provide either fixed or variable returns and offer a dizzying array of riders that can provide additional benefits.
Remember, annuities are simply a tool for transferring risk. As with any investment solution, there are tradeoffs you should weigh in determining whether the product recommendation best accomplishes your goal — and at what cost. We advise consumers to keep that in mind, because some annuity sellers don’t fully explain the costs and tradeoffs.
Let’s explore just some of the lesser-known pitfalls of annuities.
1. Just wait for the tax surprise.
Annuities are often touted for their tax-deferral. Earnings in annuities are tax-deferred — but only while they are in the account. Once you take money out, any gain is taxed as ordinary income. That may be fine for you, but what about your beneficiaries?
Unlike marketable securities held in a taxable account, your heirs don’t get a step-up in cost basis on annuity assets at your death. Beneficiaries of annuities must pay ordinary income tax on gains and must commence annual distributions (based on their life expectancy) following your death. An investor who bought $500,000 in a S&P 500 ETF and saw it grow to $1 million would pass the entire $1 million to their heirs (assuming no estate tax). That same asset in an annuity would see only $880,000 going to heirs, assuming a 24% tax bracket (the $500,000 gain would be reduced by $120,000 because of income tax).
2. Good luck trying to understand your contract.
A good rule of thumb is “the more complex the investment, the more likely it’s enriching someone other than the investor.” For example, fixed indexed annuity providers offer “point to point” crediting, but the investor must choose monthly or annual valuation, and the fees for each option differ. Then there are crediting caps, participation rates, buffers and floors that also impact the actual return on your annuity investment. Many annuity providers feature a menu of esoteric index options. One product I reviewed offered two “AI-powered” indexes, along with the S&P 500 FC Index.
How the contract credits returns can also be difficult to decipher. Some products offer “annual reset,” while others use a “high-water mark” method. Remember, most indexed annuities only calculate index returns based on the price movement, not any dividends. That means the historical annualized S&P 500 index return (about 10% over the last 50 years) gets reduced by about 2% to 3% when excluding dividends.
3. That rider is a money maker (for the seller).
Riders are “bells and whistles” that add features to a standard annuity — and they come at a cost. Here are just a few of the annuity riders I’ve come across, with the cost noted in parentheses:
- Annual liquidity rider (.95%)
- Strategy charge (1.25%)
- Guaranteed minimum income benefit rider (1.4%)
- Guaranteed death benefit rider (.35%)
- Lifetime income rider (1.5%)
These riders reduce your credited return, which makes it imperative to analyze the cost vs the potential benefit. For example, if you purchased an annuity tied to the S&P 500 with a one-year point-to-point cap of 9% and added a 1% rider, your credited return in any one year would be 8%, even if the S&P 500 returned 12%.
4. You’re more likely to be a redhead than collect that death benefit.
Many annuities offer a “death benefit” rider, which promises that when you die, your heirs will get back your original investment, even if the account is worth less than that. Before purchasing such a benefit, calculate the odds of such an event happening.
For example, the statistical chance a 65-year-old man will die within three years is 4.7%. And historically, the S&P 500 has a 15% chance of experiencing a loss in any rolling three-year period. Combining those odds puts the chances of both happening at less than 1%. Is it worth paying 1% per year (or more) for such a low-probability event?
5. You’re locked in.
To paraphrase the Bard, parting is such expensive sorrow. Want to take your money out of the Athene Performance Elite 15 annuity? It will cost you 15% the first two years after purchase. And the surrender charges last for 15 years!
In addition, most annuities charge surrender fees not only to principal but to earnings as well. Annuities are among the most lucrative products a commission-compensated adviser can sell — so be sure to understand the seller’s motivation in their recommendation.
Trying to remove or control emotion in financial decisions is challenging. If you consider an annuity purchase, understand the risk you are transferring and its probability of occurring. Additionally, be sure to understand the specific features of the contract — don’t blindly accept a seller’s explanation.
Mike Palmer has over 25 years of experience helping successful people make smart decisions about money. He is a graduate of the University of North Carolina at Chapel Hill and is a CERTIFIED FINANCIAL PLANNER™ professional. Mr. Palmer is a member of several professional organizations, including the National Association of Personal Financial Advisors (NAPFA) and past member of the TIAA-CREF Board of Advisors.
Capital Gains Tax Exclusion for Homeowners: What to Know
Tax Breaks The IRS capital gains home sale exclusion can be a valuable tax-saving tool if you’re eligible.
By Kelley R. Taylor Last updated
Kiplinger's Mutual Fund Guide For 2024
Giant U.S. tech stocks dominate many of the top-performing names in Kiplinger's mutual fund guide, but small and foreign companies are well represented too.
By Nellie S. Huang Published
The Three Basic Components of a Good Estate Plan
Getting your estate in order so everyone knows what you want when the time comes can save your loved ones confusion and stress.
By Jason “JB” Beckett Published
Is Your Financial Adviser Listening to You?
Survey finds financial advisers and their clients might need to break out the talking stick. Repetition and summarizing are key to ensure your points are heard.
By Suzanne Norman, CIMA®, CPCC Published
Did You Get a Cash Windfall? The Case for Doing Nothing
An inheritance or lottery win can be a stroke of good fortune, but if you mismanage your funds, you could end up worse off than before your windfall.
By Samuel V. Gaeta, CFP® Published
How to Use Your Estate Plan to Save Tax Now: A Timely Update
Consider an upstream basis trust and a general power of appointment for an older family member to reduce capital gains taxes on highly appreciated assets.
By John M. Goralka Published
Three Common Mutual Fund Misconceptions Debunked
Mutual funds let investors access a basket of securities rather than buying individual ones on their own, but there are some misconceptions about them.
By Brian Spinelli, CFP®, AIF® Published
529s: No Longer the Ho-Hum Investing Device for College
Changes to the plans allow for the savings to be rolled into a Roth IRA, as long as certain rules are met, if a child decides not to pursue their education.
By Neale Godfrey, Financial Literacy Expert Published
To Make the Case for Equities in the Long Term, Look to the Past
While cash yields are attractive now, if we look at the performance of equities in the past, we can expect that, going forward, they could be a better bet.
By David Blanchett, PhD, CFA, CFP® Published
Workplace Financial Coaching Has Become Ever More Important
Employees face growing challenges to their financial wellness today, so it’s more critical than ever that employers provide the help they need to navigate them.
By Greg Ward, CFP® Published