5 Things You Should Know About Annuities

Income for life is nice, but it comes at a price

by Kim Lankford, AARP, May 21, 2020 

1. They're simple — and complicated.

3. You need to know what you want.

Income annuities provide guaranteed lifetime income. But there are other types of annuities that are much more complicated and potentially much more expensive (see the next section). Most of them may be more appropriate for sophisticated investors. Among these types of annuities:

• Deferred fixed annuities can offer to pay a guaranteed rate of return on your investment for a set period of time, and taxes on the amount that you earn above what you initially invested are deferred until you take withdrawals.
• Variable annuities let you invest in mutual-fund-like accounts and the money also grows tax-deferred. However, a normal variable annuity also exposes you to the risk that your investments may lose value. These annuities are more an investment vehicle with tax benefits than a way to get guaranteed retirement income.

An income rider to a variable annuity guarantees, for an additional fee, that you'll receive at least a minimum income for the rest of your life, no matter what happens to your investments.

Income riders are complex. For example, a rider may guarantee that the amount on which your eventual withdrawals are based increases by 5 percent per year, or lock in the high point that your investments have reached, even if the value drops after that. You can then withdraw up to 5 percent of that amount each year for your lifetime — no matter what actually happens to the investments. But if you take all of your money out of a variable annuity with income guarantees, you'll only receive the actual investment value, not the higher benefit base from the guarantee.

These annuities are most attractive to people who want to (and can afford to) risk some of their money in the stock market but plan to retire within three to five years and worry about a downturn in the first few years of retirement. “If it's a bad first five years, it's really difficult for you to recover from it,” says Mark Cortazzo, a certified financial planner and founder of MACRO Consulting Group in Parsippany, N.J., who helps people compare variable annuities and other investment options.

• Fixed-index annuities let you benefit from a portion of a stock-market index's gains but protect your investment if the index declines. They typically tie their performance to an index, such as the S&P 500, but don't provide dividends. If the investments grow, you will usually only get part of that increase, such as 80 percent of the index's price increase, or a maximum percentage increase such as 6 percent, even if the index grows by much more. But the amount that you invest may be guaranteed not to lose money.

4. Safety comes at a cost.

The fees for income annuities are embedded in the payouts, and the safety comes at a cost because you can't access your principal in a lump sum after you hand it over to the insurance company.

The fees for variable annuities are spelled out in the prospectus, and while they may have advantages, they can be expensive compared with other types of investments. The average fees for variable annuities without additional features were 2.211 percent in 2019, according to Morningstar. Adding an income rider brings the average cost to 3.2 percent. This can be as much as two to three times what a 401(k) plan investor might pay.

However, some companies offer lower-cost annuities, such as one that charges just 0.25 percent for initial investments of $10,000 or more (or 0.10 percent for contracts of $1 million or greater) and has no surrender charges, but doesn't include an income guarantee. If this type of investment interests you, it is worth shopping around for the best deal.

Fixed-index annuities don't have fees spelled out separately; they're built into the structure of the product. For example, you usually don't receive dividends from the index and may receive only a portion of its gains. “Their performance is more like bonds than stocks,” Maurer says.

And both types of annuities can have hefty surrender charges if you want to withdraw the money you invested in them during the early years. For example, you'll typically have to pay a surrender charge of 7 percent if you cash out the annuity in the first seven years, with the charge gradually decreasing each year you own the investment. “Some fixed-index annuities have longer and higher surrender charges,” says Patrick Carney, a certified financial planner with Rodgers & Associates in Lancaster, Pa.

5. The seller — and the salesperson — matter.

Monthly payouts for income annuities (the kind discussed at the beginning of this article) can vary a lot by company, so it helps to work with a broker or adviser who deals with several insurers and can show you the best rates for your age and type of payout. In addition, a number of comparison websites can provide price quotes from several insurers for immediate and deferred-income annuities.

Since you're counting on the income to continue for the rest of your life, look for an insurer with a financial-strength rating of A or better, Carney recommends. Several providers, including Fitch, A.M. Best, Moody's and Standard & Poor's, rate insurance companies’ financial strength. Their ratings can be found online.

Variable annuities are not as easy to compare. The investments and fees can vary significantly, and it gets much more complicated when analyzing income benefit riders. Fees are based on terms that may be defined differently from company to company. Companies may also differ on how investment gains are measured and how often measurements are made.

Fixed-index annuities can be even more complicated. Performance can be based on different indexes and limited by complex participation rate calculations or caps. In all cases, if you don't understand exactly what you are paying for, ask questions or consider a different type of investment.

"Annuities have historically offered some of the highest commissions for salespeople,” Maurer says. In other words, some advisers have every incentive to sell you a product regardless of whether it best suits your needs. You may only be getting part of the story if you work with a salesperson who only sells annuities and doesn't explain your alternatives.

Finally, if you already have an annuity and discover it might be too expensive or not the right fit for you, you need to be careful before cashing it out — you could end up with a big tax bill or surrender charges, and you may lose an income guarantee you had locked in. Make sure that you understand the potential cost and your alternatives before acting.