Annuities are among the worst investments an investor can make for their retirement. In this article, we will explore nine reasons why you should never buy an annuity.
All Gains are Taxed as Ordinary Income
Annuities do not qualify for favorable tax treatment in the form of qualified dividends or long-term capital gains. With an annuity, all gains in the contract will be 100% taxable at ordinary income tax rates. This negative tax feature makes annuities highly undesirable investments.
No Step Up in Basis
Annuities do not qualify for a step up in basis when you die. Instead, your beneficiaries will inherit your cost basis. In the table below we are comparing an annuity to traditional investments such as stocks or real estate. In both examples we are using after-tax funds. For the investor who dies with a $2m gain on their stocks or real estate, their beneficiaries will avoid paying tax on this gain because they will inherit the investments at the market value on the date of death. In other words, the beneficiaries cost basis will be the date of death value of the investments resulting in the investments passing tax-free to the beneficiary. With an annuity however, when you pass away, your beneficiaries will eventually be responsible for paying taxes at ordinary rates on any gains existing in the contract at the time of your death. In the example below, the net amount inherited for the annuity will be $100s of thousands less after the beneficiaries pay the tax bill on the inherited gain in the contract.
Fees
Annuities have high fees. Annual fees for variable annuities can be over 3% per year, especially if you add optional benefits to your contract. In the example below, for a $1 million variable annuity contract, the investor is paying 3.75% per year in mostly hidden fees. When fees are this high, your ability to grow your wealth is significantly limited.
Hidden Commission
Annuities generally have a large and hidden commission. For variable annuities, a typical commission is 7%. We can see in the table below that for an investment in a variable annuity with a 7% commission structure, the agent will receive a $70,000 commission. This commission will not be transparent.
CDSC
Most annuities have a CDSC schedule attached to the contract. CDSC stands for contingent deferred sales charge. CDSC exists to cover the commission paid to the agent who sold you the product in case you terminate the contract before the insurance company has had your money long enough to earn a profit on your policy. When you buy an annuity, the agent will get the entire commission right away. If you were to pull your money out shortly after purchase, the insurance company would lose money since they paid the agent all the commission and would not have had a chance to earn fees on your money. In the example below, which is typical for variable annuities, we see that an investor must wait eight years to be able to liquidate this annuity without paying a massive penalty. Be aware of CDSC when you buy an annuity and make sure to compare the CDSC schedule with your future cash needs.
Conflicts of Interest
The playing field for annuities is not level and consequently financial advisors who sell them have serious conflicts of interest. When a financial advisor can get paid a different commission percentage on one annuity vs another, the financial advisor has an incentive to sell the annuity with a higher commission rate. This situation creates a major conflict of interest that can result in you being sold a product that is not in your best interest. The example table below shows typical commissions for various types of annuities.
Limited Ongoing Advice.
Because Financial Advisors who sell annuities with commissions will receive the bulk of the commission upfront, they have little incentive to give you advice on the annuity after they have been paid. Similar to a used car salesman, you won’t hear from them again until it is time to make another sale.
Misleading Riders aka Optional Benefits
Insurance companies like to add riders to annuity policies to increase the fees they can generate from the contract. Often, these riders are misleading and offer you little, if any, value. You want to be very deliberate when evaluating any riders on an annuity contract. The most misleading rider in my opinion is the lifetime income rider that is sold on variable annuity contracts. There is no lifetime income at all. When you buy a variable annuity with a lifetime income rider, once you start taking money out of the contract, you are only spending your own money. The insurance company forces you to use an asset allocation investment strategy and then meters your own funds back to you at a maximum distribution rate, under the guise of lifetime income. When did spending your own money become a lifetime income stream? The insurance company would only have to provide you with income in the rare event that you spend all of your money in the contract. Only if your contract runs out of money will you actually receive a lifetime income benefit from the annuity. The insurance company is fully aware that by forcing you to use a balanced investment strategy and controlling the distribution rate, you are far more likely to die before the contract runs out of money. By framing the rider as lifetime income, the insurance company has found a sneaky way to charge you fees for your entire life and most likely never have to pay you any actual income.
Limited Investment Options
Annuities have a menu of investment options that is often very limited. Why would you ever want to limit your investment options? Giving up the ability to buy T-bills, CDs, bonds, ETFs, stocks, mutual funds, real estate, and indexes to instead be pigeon-holed in an annuity contract with a short menu of investment product options makes no sense at all.
Ethan S. Braid, CFA
President
HighPass Asset Management