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.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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.
Related Content
- Too Heavy in Stocks? Annuities Could Be a Rebalancing Option
- Advisory Annuities Let You Eliminate the Middlemen
- Considering Annuities? Here’s What to Keep in Mind
- Annuities Have an Awareness Problem: Why That Matters
- Why So Many Experts Consider Annuities a Win for Retirees
-
2025 Virginia Tax Rebates Coming Soon? What to Know NowTax Rebates Given a historic 2025 gubernatorial race, tax policy will remain a key issue for Virginians in the months ahead.
-
What to Know Before Flying With Your PetFrom documentation and TSA screening to carrier rules and airport relief areas, here’s what to know before taking your pet on a flight.
-
Trump Tariffs and Taxes: Waiting to See What Happens Is Not a StrategyLike presidents, tariffs come and go. Policy changes also shift about every two years with the election cycle. If you're paralyzed by uncertainty, you could be missing opportunities to benefit your financial future.
-
Is a Family Office Right for You? The Multimillion-Dollar QuestionAs ultra-high-net-worth individuals increase in number, many are turning to family offices to manage their complex finances. Here's how family offices work, courtesy of a finance professional.
-
This Is How a Lot of Law School Students Are CheatingGrowing numbers of students are falsely claiming a learning disability to score more time to take tests. This has real-world consequences in which fellow students, law firms and their clients pay the price.
-
If You're Ignoring Private Markets, You're Missing Most of the ActionPrivate markets are becoming increasingly essential for all investors, not just institutions, and they are now more easily accessible thanks to innovative investment structures.
-
Three Ways Women Can Keep Caregiving From Draining Them FinanciallyMany women care for older relatives. While commendable, it could put their retirement at risk … unless they find a way to prioritize themselves.
-
I'm a Financial Professional: This Is the Roth Conversion Mistake Too Many People MakeConverting your traditional IRA to a Roth can be a fantastic tax-saving move, but you've got to be smart about two things: how much and when.
-
The Overlooked Generation: An Expert's Guide to How Gen X Can Finally Get AheadA perfect financial storm has been lashing this generation for years, but they still have time to get their retirement back on track with a few key moves.
-
Financial Advice and Retirement Confidence: What's Wealth Got to Do With It?This retirement researcher notes that retirement confidence increases the most for those with access to advice who have a lower total level of savings.
