If you read the fine print in annuities' thick prospectuses, it becomes clear most annuities are costly and restricting — and not a wise choice for your retirement investments.
Whether you are currently retired, or in the process of retirement planning, chances are someone has suggested buying an annuity.
And it probably sounds great. Tax-sheltered growth until you need the money, then guaranteed income! Market-like returns with less risk! Big benefits for your loved ones! You might even think it sounds too good to be true — and you're right: It is.
If you read the fine print in annuities' thick prospectuses, it becomes clear most annuities are costly and restricting—and not a wise choice for your retirement investments. In fact, our CEO Ken Fisher believes anything that can be done with an annuity can be done a better way.
The Pitfalls of Variable and Indexed Annuities
There are two main types of stock-based deferred annuities: variable and indexed.
Variable annuities let you invest your principal in an array of pre-selected subaccounts, similar to mutual funds, and your funds rise and fall with the market. The subaccounts may have higher return potential, but high fees eat away most of it.
As our analysis shows, variable annuities' multi-layered fees severely erode compound growth potential. Variable annuities also carry stiff exit penalties, called surrender charges. By the time you figure out the annuity is a raw deal, leaving is usually costly. Typical surrender charges start at 7% of the total contract value (double digit charges aren't unheard of, though), with the penalty declining gradually as time passes.
Indexed annuities' returns are linked to a stock index — usually the S&P 500 — but have a return floor and ceiling. Your account doesn't lose value when the market falls, but you don't reap anything resembling market-like returns either, which can reduce your ultimate income stream.
Annuities and the Provider
With both variable and equity-indexed annuities, the provider (typically an insurance company) pockets a huge chunk of your returns — either through variable annuities' high fees or by capturing the difference between the market's return and your capped return in an indexed annuity.
But this isn't the only way deferred annuities likely benefit the provider more than they'd benefit you. For one, to get the much-advertised "guaranteed" income, you must annuitize the contract, which requires you to turn your entire principal over to the provider. In other words, they take ownership of your money.
Moreover, these firms aren't charities, and they structure the payouts to ensure their business can still make money on the contract. Some don't adjust payouts for inflation. Others layer on more fees. Benefit riders are also expensive.
Annuities and Taxes
Annuities' tax treatment isn't all it's cracked up to be, either. It's true that funds in an annuity aren't subject to income or capital gains taxes. (Incidentally, this is why the SEC cautions against purchasing annuities in IRAs: Since IRAs are already tax-deferred, annuities provide no additional tax benefit.) But annuity funds aren't tax-free. They're tax-deferred.
When you withdraw money, you must pay ordinary income tax rates on any amounts above what you put in. Compared to a taxable investment account, the tax rates on your annuity income could be significantly higher than what you would have paid without an annuity.
The Verdict on Annuities for Retirement Planning
After having been in the business for over twenty years, at Fisher Investments, we believe deferred annuities are a raw deal. You end up paying a lot for minimal benefits, and in many cases, you'll end up behind where you could be with a more traditional, less complex approach.
We encourage investors to explore all their options. If you're considering an annuity for your retirement planning, we suggest thinking about why the annuity is attractive, what your long-term goals and needs are, and then investigating how a simple portfolio comprised of stocks, bonds; cash and other securities might better serve you.