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Annuities: The Good, the Bad and the Ugly

by on October 14, 2018 5:00 AM


By Judy Loy
ChFC®, RICP® and CEO of Nestlerode & Loy, Inc.

Depending on what or who you read, annuities are either the best thing for people in retirement or the worst investment option available. In reality, annuities have gotten a bad rap for several reasons.

Typically, they pay a lot to the brokers who sell them. For this reason, annuities have been oversold and possibly sold in the wrong instances. Annuities are also very complexed products and difficult to fully explain to a normal investor. This makes it hard to disclose all details clearly without the investors’ eyes glazing over. Even in this article, I will be simplifying strategies and types of annuities. Please read carefully material on any annuity you want to purchase and ask questions. New annuity options are constantly being created and modified so each annuity should be studied and decided upon based on the individual’s or couple’s’ unique situation.  

First, to sell an annuity, the advisor needs to have an insurance license because annuities are considered insurance products and sold by insurance companies. An annuity is a contract between the purchaser and an insurance company. The purchaser pays money to the insurance company (the issuer) in return for an income stream to the purchaser or another named beneficiary.

A major advantage of annuities is their tax deferral. Once money is invested inside an annuity, all growth and dividends kept inside of the annuity are not taxed. Due to the tax-deferred nature of annuities, withdrawals are limited and typically face a 10 percent early withdrawal penalty if taken prior to age 59 ½. Thus, putting retirement money (IRA, Roth, etc.) in an annuity duplicates one of the main benefits of an annuity and should be considered carefully. Other factors in this specific annuity would need to be very beneficial to make it worthwhile. Because an annuity is tax-deferred, when you can pull from the annuity without penalty, you face income tax rates on any gain. This is different from other investments where gains are taxed using capital gains rates.

Another major advantage of an annuity is the ability to turn a lump sum or periodic payments into a guaranteed income in retirement. This is the main reason to buy an annuity. The problem is many annuity owners never use this feature and are lulled by the ‘guarantees.’ In simple terms, when you annuitize, you lock away your lump sum or principal that is inside your annuity and give it to the insurance company permanently. In return, the insurance company promises you a certain payment amount each year based on your life or within a certain period of time (10 years, etc.).

Major disadvantages of annuities are commonly surrender charge periods and high fees. Most annuities have a surrender charge period, which means for a certain time, the owner is unable to pull more than 10 percent a year without penalty. This does not apply to annuitization. Therefore, annuities are almost never liquid products. If you will need the principal of the money you plan to invest, do not invest in an annuity. The surrender charge periods that I have seen range from seven years to 20, with 10 being typical. The surrender charge amount goes down over time until it reaches zero.  If you are considering an annuity, be sure to know the surrender charge details.

Another disadvantage of annuities is their fees. There are typically four types of fees:  insurance charges, administrative fees, surrender charges and rider charges. These can add up and vary by company and guarantees offered. Overall, the more guarantees and features, the higher the underlying fees will be and the longer the surrender charge period. You pay for what you get.

There are four basic types of annuities.

A fixed annuity contract is sold by an insurance company and has an initial guaranteed rate of return. The product then has a fixed rate that varies but a guaranteed minimum rate usually applies. The growth of the account will vary with the interest rate environment.

A variable annuity is a vehicle for equity investments and the advisor who offers it must have an insurance and broker’s license. The growth of the account will vary with your investment decisions inside the annuity. A variable annuity has additional costs, which are the underlying investment fees.

An immediate or deferred annuity describes how soon the insurance company begins paying you back for your investment. For an immediate annuity, the purchaser invests a lump sum and immediately gets payments based on the estimated or certain period payments are to be made to the owner and possibly a beneficiary. A deferred annuity will pay at some future date that is predetermined or chosen in the future by the purchaser. In this case, the owner can put money in a lump sum or through periodic payments.

There a lot more details involved with annuities, their options, their benefits and downsides. The most important thing is to know the details of the one you are thinking about purchasing. With any investment, but particularly annuities, knowing what you are getting and what you are paying for is key.  Annuities are more complex than other investments, so it takes longer to get the full picture.

Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector. Annuities are complicated products and each policy should be reviewed carefully with a fiduciary advisor.



Judy Loy, ChFCâ, is a Registered Investment Advisor and CEO at Nestlerode & Loy Investment Advisors, State College, Pa. A graduate of Penn State University, Loy has been with the firm since 1992, assisting clients with retirement planning, brokerage services and investment advice. She can be reached at jlo[email protected]
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