Annuities are bad investments designed to hold you hostage for the duration of your life. Annuities are nothing more than a complicated trap that many investors fall victim to. Here are the four most common ways investors get trapped in annuities.
- Taxes
- Death Benefits
- Riders
- CDSC
Taxes
Annuities are tax-disadvantaged investments. When you purchase a non-qualified annuity using after-tax funds, any gains in the contract will eventually be taxed as ordinary income. Instead of paying low tax rates like the tax rate for qualified dividends or long-term capital gains, annuities pay the highest tax rates.
Investors get trapped in annuities once the annuity has increased in value and the investor realizes that getting out of the annuity will result in a large tax bill, potentially moving them up to higher tax brackets depending on the distribution amount.
In my 25 years in wealth management, I have met dozens of investors who were stuck in an annuity they did not want to be in but refused to get out of the annuity because of the taxes they would have to pay after withdrawing their money. The person who sold them the annuity never explained how the annuity would be taxed.
Unfortunately, the tax problem never goes away. When you die, your beneficiaries inherit your cost basis in the annuity and eventually they will be responsible for paying income taxes on any gains in the contract they inherit. Unlike traditional investments such as stocks, bonds, ETFs and real estate, that receive stepped up cost basis when you pass away, annuities do not qualify for stepped up cost basis. Therefore, when you invest in a non-qualified annuity, you are setting your beneficiaries up for an unnecessary and potentially large, tax bill.
Death Benefits
Annuities have many different death benefit options. These options are a form of insurance on your annuity contract offering your beneficiaries some guaranteed payment amount when you die. These death benefit options are not free and result in substantial, additional ongoing cost for your annuity.
Frequently I meet investors who are trapped in an annuity they want to get out of but refuse to end the annuity contract because they do not want to give up the death benefit. Instead, they stay in the annuity and continue to pay outrageous fees, often well over 3% and sometimes over 4% per year, because the fear of giving up the death benefit is just too great. Sometimes this fear is justified and often it is not. In some cases, if you have been in an annuity for a long time, the death benefit may be the only reason to keep the annuity. But what ends up happening is you just keep paying astronomical fees until you die. Nearly always, if you had just bought indexes or an asset allocation fund and stayed invested vs buying the annuity, you would have ended up with far more money than the death benefit. The cost of paying 3% or 4% per year in annuity fees seriously hinders your annuity accumulation value potential.
If you are still insurable, investigate the cost for buying a 10-year term insurance policy to make up the difference between the annuity surrender value and the annuity death benefit. Compare the cost of term insurance to the cost of keeping the annuity. Ten years of life insurance coverage gives you enough time to grow the funds you would receive from surrendering the annuity. You may be able to achieve a better long-term outcome by taking control of your investments, lowering your investment costs and replacing your annuity death benefit with cheaper, term insurance until your investment value has surpassed the death benefit you gave up from the annuity. While this strategy will not be feasible for everyone due to age, insurability, etc., it should be explored.
Riders
Annuities are usually sold with complicated riders such as income for life, guaranteed withdrawal balance (GWB), guaranteed minimum withdrawal benefit (GMWB), guaranteed minimum death benefit (GMDB) on and on. These riders can be very expensive, sometimes over 2% annually. To truly understand how these riders work, it is imperative that you read the prospectus for the annuity you purchase, before you make the purchase. The prospectus will be a massive document that is nothing but fine print, legal terms and technical jargon. Recently I reviewed a prospectus for someone trapped in an annuity and the prospectus was over 300 pages. The document was incredibly complex and very difficult for a layperson to read and understand.
Investors get trapped in annuities by signing up for expensive riders that hurt their accumulation value. Years down the road, these investors realize they were duped when they see how poorly their annuity has performed relative to indexes like the S&P 500 or Bloomberg US aggregate bond. When the investor understands how poorly their annuity has performed, they naturally want to get out of the annuity but often balk because they fear giving up the rider. Instead, they stay trapped in the annuity and just continue paying exorbitant fees to the insurance company; harming their long-term wealth accumulation potential.
CDSC
CDSC stands for contingent deferred sales charge. CDSC exists to claw back the hidden commission that was paid upfront to the person who sold you the annuity. When investors talk about a penalty to get out of an annuity, they are referring to the CDSC. CDSC generally lasts for about 7 years but for true garbage annuities, CDSC can exist for as long as a decade.
Too many times, I have met investors who were unaware of the CDSC schedule on their annuity. They were clueless to the fact that their so-called financial advisor received a 7% or even 10% hidden commission when they bought the annuity. They never read the annuity prospectus, and the financial advisor never told them about the hidden commission or the CDSC. When they wanted to get out of the annuity only then did they learn they would have to pay a massive penalty to get their money back.
Investors get trapped in annuities by allowing a salesperson to lock them up in a high commission product with a CDSC schedule that can last for as long as ten years. Not all annuities have long CDSC schedules, but these annuities offer much lower commissions or even no commissions to the financial advisor. In my experience, most financial advisors will steer clients to the annuity that pays them the most and imposes the longest CDSC on the client. Because annuities have different share classes with different commission options for the financial advisor, any financial advisor selling this rubbish has an extreme conflict of interest. Furthermore, no financial advisor can be a fiduciary when they are selling you an annuity for a commission. Any financial advisor who mentions the word fiduciary when selling you a commission paying annuity is lying to you. Be careful when dealing with financial advisors who peddle annuities.
Ethan S. Braid, CFA
President
HighPass Asset Management
Denver, Colorado