The outlook for annuities was dim in 2017. Now that the Department of Labor (DOL)’s fiduciary rule has, at a minimum, been postponed, annuity sales could be on the rise, as commission-based agents have the ability to sell in greater volume.
Annuities offer slick marketing materials, but sadly, the contents are often misleading. This is largely because they’re considered insurance products, exempting them from many SEC regulations.
SageVest Wealth Management proudly serves as your independent, fiduciary advisor. All of our recommendations are unbiased, based solely on your best interests. We offer the following insights on annuities, to help you become a more informed investor.
What Is An Annuity?
An annuity is a form of an insurance product, typically structured in one of five ways:
These offer a fixed interest rate, sometimes higher than the rates offered by bank CDs. The income you receive, if any, depends upon the contract parameters.
Variable annuities allow you to choose investments. With wise investing, your annuity can exceed the growth of a fixed annuity, but it is also subject to risk.
These hybrid products allow you to participate in a portion of an index investment’s performance (e.g. the S&P 500), or receive a fixed amount as a minimum return. This may seem attractive, but, like structured notes or market-linked CDs, upside potential may be limited through participation caps.
An immediate annuity begins providing income payments to you immediately or within one year of purchase.
Conversely, many annuities offer deferred payments, whereby the annuity assets remain tax-deferred until payments commence, if ever, during your lifetime.
What Are The Advantages Of Annuities?
Every annuity differs, but the main advantages center upon tax deferral and some possible guarantees.
Annuities can afford income tax deferral on investment growth, similar to that of a 401(k) or IRA. Furthermore, income deferral can extend well beyond age 70 1/2, when Required Minimum Distributions are imposed for traditional qualified retirement plans.
If you convert your annuity into an income stream (known as annuitizing your annuity), you can receive a guaranteed income payment for a specified period, or for life. Lifetime returns are typically low, unless you live well beyond life expectancy. However, the predictable income from an annuity can be attractive, particularly if you tend to overspend.
Annuities sometimes have protective loss provisions, such as offering a guaranteed minimum return, or riders that provide guarantees like a death benefit, or payment for long-term care needs.
What Are The Disadvantages Of Annuities?
Fees are the primary disadvantage of annuities, along with potentially unfriendly tax structures upon withdrawal. High fees dramatically reduce your investment return potential.
If you sell or move your annuity within a stated number of years, surrender fees often apply. . These can be up to 10% of your investment, and can extend close to a decade.
Commission fees can be as high as 10%. Some advisors who sell annuities continue providing advice post the sale. However, we frequently see agents collect their commission with no continuing advice or oversight.
Virtually all annuities impose annual fees that can be 3% per year or higher.
Taxable Income Distributions
Unless you annuitize your annuity (convert it to an income stream and forfeit your account balance), you’re typically required to take all taxable income from your annuity before you can access your original investment.
Example: Andrew buys a $100,000 non-qualified deferred annuity that grows by $80,000, to a total value of $180,000. He needs to withdraw $100,000 for a house renovation. This will generate $80,000 of ordinary taxable income, as all earnings must be distributed before Andrew can access his original tax-free investment.
What Annuity Red Flags Should I Beware Of?
In the case of annuities, there are several red flags to beware of.
The first warning sign is when you see guaranteed rates. These are often not as good as they appear:
Guaranteed Minimum Income Benefits
Annuity products frequently allow you to invest your account assets, while receiving a guaranteed rate of return. This is commonly known as receiving a guaranteed minimum income benefit (GMIB). However, this guaranteed rate doesn’t apply to your account balance, but only to a phantom account ledger that’s used to determine your future income benefits. The phantom asset ledger will grow at the guaranteed rate, but the annuity company determines how much of it you get for your lifetime income, once payments commence. You typically need to live a very long life, perhaps well past 100, to receive the guaranteed rate of return from the date of your investment.
Annual vs. Cumulative Guaranteed Rates
If a rate’s guaranteed, find out if it’s an annual or cumulative return; the difference can be significant.
Example: A 5% cumulative rate of return on a $10,000 investment over 5 years results in an ending balance of $13,401. However, a 5% total cumulative return over 5 years only results in an ending balance of $10,500.
Establish for how long any guaranteed rate is valid. Sometimes, they only last a year or two, then decline.
A guaranteed withdrawal is one of the more vexing guarantees associated with annuities. Guaranteed withdrawal provisions frequently allow you to withdraw up to a stated percentage of your assets – say 5% – annually. However, this isn’t a rate of return or investment performance, just the ability to access your assets. What’s worse is that you might actually pay an additional fee for the privilege.
Annuity Tax Benefits In An IRA
If an advisor ever tries to sell you an annuity in an IRA and references the tax benefits, our best advice is to end the conversation. IRAs are already tax-deferred. An annuity within an IRA offers no additional tax benefits.
SageVest Wealth Management helps clients to evaluate the pros and cons of existing annuities without bias, giving guidance on when they make sense, or when they should be avoided or sold. We proudly serve as a fiduciary, always putting your best interests at the helm of our recommendations. Please contact us to learn more.