Are Annuities Oversold?

If we're not careful, we can easily fall victim to pushy sales tactics to buy expensive annuities. Annuities and other life insurance products are often sold using your fears against you. There is a tendency for annuities to be oversold because of the handsome commissions paid to sell them.

To be clear, there are times when an annuity might make sense, but many retirees have other guaranteed income sources like Social Security. There are various annuities (fixed, single premium, deferred, etc.), so it can get confusing.

Understanding the Basics of Annuities

First, let’s talk about what annuities are and aren’t. Just remember, they’re just a specific financial tool, just like anything else.

What is an annuity?

An annuity, in its simplest form, is a way to transfer risk in exchange for a fee. We all have some risk of running out of money. An annuity allows you to pay an insurance company to enter a contract with you to provide a certain amount of money for a specific period.

Your costs are a combination of premiums, fees, and commissions. The insurance company’s costs are equal to the payments made to you or other designated beneficiaries listed in the contract.

How the Insurance Company Covers the Bill

Because the insurance company holds contracts with many other people, it can spread your risk with others. In general, some people will pay more than they receive, and others will receive more than they paid in. However, the insurance company calculates the estimated payments and ensures it can make a profit after paying all contractual obligations.

In short, the insurance company makes money by collecting premium payments and investing the money. They can turn a profit after paying out less than what they earn through premiums received and their investments. It’s a little more complicated, but this is the general idea behind what’s happening.

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Short Explanations of Key Annuity Types

There are many different types of annuities out there. We’re not able to explain every single type because each insurance contract is unique. There are many different options and “riders” that can be included in annuity contracts, too.

Deferred Versus Immediate Annuities

Pay attention to when the payout period begins. Annuities that start providing payments back to you right away are called immediate annuities. Deferred annuities are funded first, then the payout period occurs at some point later.

This is important to remember so you can plan when you’ll start receiving your money back from the annuity. In most cases, accessing your money once it’s locked into an annuity contract is difficult. More on this later.

Fixed Annuities

Fixed annuities are generally simpler to understand. In short, they have a fixed interest rate set by the insurance company. This doesn’t mean the rate never changes, though.

Fixed annuities can still be complicated to understand once we layer on all the options and riders you can purchase.

Indexed Annuities

Indexed annuities credit your account based on the performance of a specific index, such as the S&P 500. Once again, there’s some nuance here. There’s a limit to how much the insurance company will credit your account.

In other words, if the index selected rises by 25% in one year and your cap is 12%, you’ll only be credited 12%. This should be clearly understood before you enter the contract.

The Emotional Hook: Fear-Based Selling in the Annuity Industry

The fear of running out of money in retirement is very real for many people. However, marketing to this single fear can be taken too far. We aim to empower and support you in retirement, not scare you into buying a single product.

In some marketing of annuities, they’re painted as the only safe solution, or make you feel like you’re at a high risk of losing all your money. This hacks your brain's natural tendency to avoid loss and pain. There are risks, but no insurance product can save you from all troubles.

Market Downturn Language

Many annuity providers overstate the risk of loss in a market downturn. For example, many top annuity companies have some form of market downturn phrase: “A market downturn can put your savings at risk,” “upside potential without the downside risk,” or “Protect your principal against market downturns.”

These phrases can be misleading. We always ask the question: “Compared to what?” If you compare against an income-producing portfolio of stocks and bonds, you’ll get a different comparison than if you compared it to 100% stock/equity exposure or money just sitting in a savings account.

Market fluctuations are factored in when your money is invested to provide retirement income. Also, you don’t “lose” any money until you sell. Lastly, this “loss” is probably still a significant gain from when you first invested the money.

Why Retirement Annuity Pitches Often Sound Too Good to Be True

You’ll often be told key phrases like “guaranteed income,” “risk-free income,” or “lock in gains.” What’s frequently missing is a clear and objective breakdown of the actual costs of these annuity features. In short, there’s no free lunch when it comes to annuities.

Sales pitches might also slip in random misinformation to throw you off. For instance, we watched one sales pitch stating you wouldn’t get Social Security if you were self-employed. This is not true unless you haven’t paid taxes your whole career. In that case, you’ve got bigger problems.

You need to enter an annuity decision with open eyes, clear data, and time to think about it.

Fixed Doesn’t Mean Forever

Even standard fixed annuities aren’t fixed forever. They often have a limited period when they will credit at the current quoted rate, then adjust periodically. Many offer a “FAFY Yield,” which stands for Fixed Account First Year Yield. After the first year, your rate is determined by the fixed rate set by the insurance company.

Multi-Year Guaranteed Annuities

Some annuities have longer-term guarantees, like Multi-Year Guaranteed Annuities (MYGA). However, even MYGAs are limited. They often range from about three years to ten years.

Once the guaranteed period ends, the rate will change whenever the insurance company decides to change it. This usually happens on the anniversary of the policy start date. It’s hard enough remembering your own wedding anniversary, let alone the anniversary of your annuity.

The Good Side: When Annuities Actually Make Sense

We’re not saying annuities are inherently good or bad. There are some scenarios where annuities are beneficial. Many retirees remain concerned about running out of money, and an annuity can help.

Annuities can help provide insurance against outliving your money. A stable income to cover basic living expenses is a real stress relief. However, annuities aren’t the only way to accomplish this.

Income Predictability

An annuity can provide some stable income for retirees relying on retirement savings only (no pension, low/no Social Security, etc.). You’ll have to consider what mix of income streams will give you the best sleep at night. If having a regular deposit every month will make you feel secure, then maybe an annuity is something to consider.

There’s also something to be said for the relative simplicity of an annuity. There’s no portfolio to manage, and you’re somewhat insulated from major market downturns. If the insurance company remains in business, you’ll continue to receive your annuity payments.

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The Catch: Fees, Inflexibility, and Opportunity Cost

There are some additional downsides to annuities as well. They often have high costs and commissions. Many contracts are written in something close to “legalese,” which isn’t as easy to understand. Regulations require companies to use plain language, but several pages of disclosures and information aren’t exactly plain and straightforward; they’re often overwhelming.

The National Association of Insurance Commissioners (NAIC) has helpful guides and information on annuities and insurance products. Their Buyer’s Guide for Deferred Annuities is a good starting point. We highly recommend getting a second set of eyes from someone who’s not selling you the annuity.

Limited Liquidity and Access to Principal

Another downside to annuities is that they lock your money into the product. You must pay surrender fees to terminate the contract early or withdraw extra money, and the amount varies depending on the insurance company.

Risk of Inflation and Low Returns Compared to Alternatives

The risk of inflation is still a concern with annuities. As inflation increases, the Federal Reserve tends to increase interest rates. This could trickle down to an increased rate for your annuity, but it doesn’t lower your costs.

Higher inflation rates eat into your buying power from annuity payments. Large amounts of money tied up in an annuity could limit your ability to keep up with inflation.

There are inflation-protected annuities, but these are limited too. They may have limits on how much adjustment they will make per year. They might also start with lower crediting to offset potential future costs.

What to Watch for Before You Buy

Luckily for consumers, all investment products have required disclosures. These are mostly filled with disclaimers to make sure they can’t be sued if something bad happens. The documents you want to find are the prospectus and the contract you’ll sign.

How To Read the Fine Print in Annuity Contracts

Not all prospectuses are created equal, but they should have a section labeled fees or a fee table. This is a great starting point for estimating the base contract and all the individual add-ons (riders). Don’t overlook the rider costs, as these can cost more than the main annuity contract itself.

Many insurance companies will compare the minimum and maximum fees on a $100,000 investment. This is a little more useful than just a percentage, but it can still be confusing. Regardless, always figure out the total costs.

You want to figure out the total return net of fees and taxes. In other words, what’s the actual usable dollar amount you can spend from the payout?

Payout Rules and Tax Implications

We could write an entire article on annuity payouts and taxes. However, the main thing you need to understand is whether your annuity is qualified or non-qualified. In short, a qualified annuity is funded with pre-tax money, and a non-qualified annuity with after-tax money.

If your annuity was funded with pre-tax money, such as an annuity purchased inside your 401(k) plan, your full payment is taxable as ordinary income. An exclusion ratio (partly taxable) applies if it was purchased outside of a retirement account or IRA with post-tax money. See IRS Publication 575 for more information.

If the annuity is in a Roth account, the payments aren't taxable. However, this scenario is probably not likely or optimal because of Roth accounts' tax benefits.

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Alternatives to Consider

As we mentioned, you might not (probably don’t) need an annuity to meet your goals. There are several options for generating a steady retirement income.

Building A Bond Ladder

Bonds are a different type of investment from stocks. Because they generate income based on coupon (interest) payments to you as well as appreciation, they are generally more stable than stocks. However, bonds have different risks involved as well.

Bond maturity (the full term of the bond) and duration (the time to recover your costs) are measured in years. To build an income stream, you could stagger the maturity or duration of bonds you invest in. This allows you to receive your full investment at the end of the holding period or sell at a gain to generate income.

Managing a Diversified Retirement Portfolio with a Withdrawal Strategy

Alternatively, you can build a diversified portfolio and withdraw as needed. For most retirees, a properly constructed portfolio can provide income, combat inflation, and be easily adjusted over time. You’ll also stay invested in the market to keep getting long-term growth benefits.

We employ dynamic distribution strategies to allow for changes in your financial plan and market fluctuations.

Final Verdict: Are Annuities Worth the Hype?

So, are annuities worth all the hype? Probably not, but they do have their place. You must carefully consider the full cost, including fees, taxes, commissions, and opportunity costs. There are safe alternatives to annuities to meet your retirement needs.

All investments and contracts involve some risk. We can’t buy our way out of all risks in life, but we can plan for them and adjust as life unfolds. We highly recommend consulting with a financial planner to create a personalized strategy.

At NextGen Wealth, we start every client relationship with a financial assessment to ensure we’re a good fit and get you started on your retirement journey. We can help look at your whole picture and see if an annuity makes sense. Contact us today to start planning your ideal retirement!