Disadvantages of an annuity

Annuities have been a cornerstone of investment planning for retirees for a very long time, because at first glance, they seem like an ideal investment product.  You put in a lump or periodic sum, the principal is guaranteed with an insurance benefit, and the insurance company claims you will receive $4,500 a month for the rest of your life, which seems like a good way to secure your lifestyle in your later years.  However, lurking in the shadows and hidden from sight is the ugly truth about annuities.  Their complex web of surrender charges, hidden fees, earnings caps, and “fine print” reveal an extremely predatory product that enriches insurance companies at the expense of hard-working Americans.

The hidden costs of an annuity

When deciding on their annuity plan, participants need to make a few simple decisions.  First, should they contribute to the annuity as a lump sum or periodically over time?  Secondly, will they receive their income (payout) immediately, or deferred at some later date?   Finally, will the payout be fixed or variable based on returns from the stock market?

Variable annuities are different from a standard retirement account because include an insurance component, where the accumulated account value is converted into a guaranteed income payout for a specified period or the rest of your life. The payments are calculated by the insurance company criteria that considers your age, investment premium, account value, and life expectancy. 

The overall fees for an annuity are variable, but tend to be within 1-2% per year, plus earnings caps on the amount that you can gain on your investments.  The result is an extremely sub par product that massively eats away at your wealth over time.

• Surrender charges: All annuities have penalties for participants that switch out of them within a specified period.  The insurance company charges these penalties so they can recoup the initial cost of the annuity plus any sales commission to the salesperson that sold it. The result is that annuities are decidedly less flexible than most investment products.

• Mortality, expense and administrative fees: The insurance company generally deducts a variety of fees for annuity maintenance, bookkeeping and administration.  These fees are based on the total value of the annuity and run between 1 and 1.5% annually.  

• Mutual fund fees: Participants also pay management fees or expenses imposed by the funds they are invested in (called an expense ratio), just like they would with any other type of investment.  In annuity lingo these are called “sub-accounts”, and their overall cost can vary widely.  

• Special features: Special features on annuity products impose additional fees. For example, an investor might pay for a small additional death benefits or a cost-of-living provision, but these costs can add an additional 0.3 to 0.8% onto the base fee amount.

• Earnings caps: Many annuities set floors on market performance so the participants account value cannot go down below a specified value, but they usually also have an earnings cap that limits upside potential when the stock market is performing well. For example, a fund with a 10% cap will only earn that much even if the underlying investment earns 18%.  This can lead to significant “losses” over the long term.

What are the alternatives?

A fixed income portfolio developed by a fiduciary Registered Investment Adviser (RIA) can generate a steady interest based payout at a much lower fee basis than any annuity product.  These portfolios invest in bonds, short term treasuries, real estate, and dividend paying stock, and can easily target between 3 and 5% annual return on your investment.  More importantly, the fees are likely to be nearly half of an annuity.  Generally, advisory fees would be between 0.7% and 1.2% depending on the company and account size, with the only other fees being those imposed by the underlying funds.  For example, at Arrow, we would build a fixed income portfolio from an investment of $400,000 for only 0.75% annually.

Many investors are concerned with the risk involved in being a portfolio like this, but the reality is that the same type of safeguards used by insurance companies in annuities can be baked into certain types of funds in a fixed income portfolio as well.  For example, consider the defined outcome ETF’s offered by Innovator Capital Management, which simultaneously buffer downside losses and cap gains.  Sounds a lot like an annuity right?  The reality is that many types of downside protection can be used in a fixed income portfolio for a much cheaper overall cost than in an annuity.

Final Thoughts

It’s important for investors to consider the annual costs of an annuity and how they add up over time, particularly when additional fees kick in later in the life of the annuity.  It’s also important to think about who is selling you these products.  Remember, they are sold by insurance companies using an army of “financial advisers” that are actually insurance salespeople working on commission.  They are not fiduciaries, and have no incentive to do anything other than to sell you a product.  They do not have your best interest in mind.  Consider using a fiduciary RIA that is fee-only, and has moral and legal obligation to work in your best interest.  Not only will you pay less, but you’ll have an investment professional on your side, not a predatory insurance company!