While annuities can be an integral part of a financial plan, if misused, they can have unexpected consequences. For those unfamiliar with how annuities work, you are giving the insurance company your money in return for an income stream, typically for the rest of your life. In the event you die, the insurance company may keep all of your money depending on whether you have commenced payments, and what payment option you have selected.
1. Deferred Annuities Do Not Belong In Retirement Accounts
It makes little sense for a tax deferred account such as an IRA to hold a tax deferred annuity. In this case, you are paying fees for the tax treatment that the government is giving you for free.
2. Variable Annuities Can Be Complex And Expensive
These contracts contain highly complex language that most people find hard to understand. Annual fees in the range of 3% – 4% can be a significant drag on investment performance. Investment menus generally consist of a limited number of mutual fund options that can have high fees. Once your investment selections are made, who will be watching over your investments? Salespeople typically do not want to be responsible for providing continuous supervisory services on your account.
3. Beware Of Surrender Charges
Let’s say you purchase an annuity and have a change of heart or circumstances and want your money back. If you are within what the insurance company calls a “surrender period,” typically 5-7 years after the contract date, you may have to pay a surrender charge of up to 7% to get out of the contract. Be aware that you may be tying up your money for an extended period of time.
If you choose to “annuitize” and receive payments, you are making a bet that you will outlive the insurance company’s life expectancy tables. Should you die prematurely, you may not have received your money back from the insurance company, or even have funds available to leave to your heirs – unless you elect a Period Certain payout. It’s possible that you may have only received a few payments before leaving the rest of your money to the insurance company.
Annuities are attractive for those who want a guaranteed monthly income.
While a guaranteed monthly income can seem appealing, you have to consider the pernicious impact of inflation and rising rates over time. The combination of low inflation and interest rates today may not look very attractive should we have a sustained increase in inflation and or interest rates in the future.
Annuities can be a great tool for the risk averse in need of an income stream. Since annuity payments include a return of your principal, they will deliver a much higher “yield” or monthly payment than other fixed rate products. Turning your nest egg into an income stream can be a big decision for retirees. Before purchasing an annuity make sure you understand what you’re signing up for.