Why Annuities Are So Controversial

June 2, 2023

Why Annuities Are So Controversial

June 2, 2023

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Have you been searching for financial options to help ensure a steady income stream in retirement? Have you come across the word “annuity” as one way to do this but, after researching further, realized that not everyone is on board the annuity train? We believe annuities may be a viable option for some to help produce a guaranteed income stream in retirement, but it’s important to understand the full picture of what an annuity can and can’t offer— the associated pros and cons—and that it may not be the right option for everyone.

An annuity is a contract between you and an insurance company with an agreement to pay you a regular income now or in the future; annuities are purchased with a lump sum or a series of payments—this is considered your “principal,” or your initial investment. The insurer uses a variety of strategies (depending on the product) to grow your annuity funds. Annuities can be used to protect or grow your income or to provide you with a guaranteed income in retirement. Think of them as a way to provide insurance for your retirement, helping mitigate the risk of outliving your retirement income. Annuities can be fixed, variable, or indexed, and the income can be paid out immediately or deferred for a certain time period. Annuities can be purchased from banks, insurance companies, or other financial institutions. You can read more about annuities here. This product can be a viable option for retirees looking to generate more income in retirement; yet they are often viewed with a certain level of skepticism due to their complexity and the fees associated with them.

In this blog, we’ll explore why annuities are so controversial, and what are their potential benefits and drawbacks.

Why Are Annuities Controversial

Ken Fisher, whose investment firm manages over $192 billion for private and institutional investors globally, is one of the most prominent critics of annuities. He speaks out against them because, in his opinion, “Annuities are often sold with the promise of ‘guaranteed withdrawals’ or ‘minimum returns,’ but the reality is annuities are complex and don’t always provide the safety they may promise. High costs, withdrawal restrictions and other risks can offset promised benefits, and the brokers that sell them are often incentivized by high commissions.”

They’re Complex

One of the reasons annuities are so controversial is their complexity. There are many different types of annuities, each with unique fees, features, and risks. Additionally, complex language and concepts in the annuity’s long prospectus and contract add to potential confusion. This is where a financial professional can help distill the complexity into simpler terms and help you wade through all the fine print.

On the flip side, because annuities are sold by insurance companies, banks, and other financial institutions, they are subject to the regulations of both the insurance and securities industries. Per Investopedia, “Annuity products are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities.” They’re a highly regulated financial product, and knowing you are buying something under federal oversight may give you some peace of mind.

They Can Have High–or “Hidden”–Fees

Another reason annuities are considered controversial is the fees associated with them. Annuities typically have both upfront and ongoing fees, which can significantly reduce an investor’s return and make this a costly investment. According to Smart Asset, when you buy an annuity, you may have to pay the following fees:

Administrative Annual Fees – Annuity companies typically charge either a percentage or a flat fee for administrative costs. The rate typically will not exceed 0.30% if it’s a percentage. For a flat fee, the rate ranges from $50 to $100. Some companies waive the fee if the contract exceeds a predetermined amount.
Investment Expense Ratios – When investing in a variable annuity, your money is linked to an underlying investment such as mutual funds, ETFs, or index funds. Each of these types of funds has an expense ratio that is deducted from the assets invested in the fund, and these rates can range from low to high but generally do not exceed 2.5%.
Surrender Charges – The terms of an annuity contract will determine if there is a surrender fee and how much it is. Generally, the fee will decline annually until it disappears.
Mortality and Expense Risk Charges (M&E) – An annuity is a form of insurance distinct from investments such as stocks or bonds. To cover the risk associated with providing the annuity, insurers charge mortality and expense risk fees, which remain constant regardless of any changes to the annuity holder’s mortality risk or life expectancy. Generally, these fees range between 0.50-2% of the annuity’s value.
Commissions – The more comprehensive the features of an agreement, the higher the associated commission. Fixed annuities usually have lower fees than variable annuities with a wide range of investment options. Usually, the maximum commission for any deal is no more than 10%.
Annuity Riders – Annuities provide a set of features that may be enhanced with riders. These riders come with an additional fee, which can vary. It’s essential to know these fees in advance.

The fees associated with an annuity can make investing in them less attractive than other options, such as stocks, index funds, and bonds, which generally have lower fees. Some annuities have no or low fees; however, it’s important to account for everything you’ll be charged for when choosing an annuity. Ask for clarification from a financial professional if you don’t fully understand your annuity contract (before signing anything!).

Conversely, annuities have potential tax benefits. According to CNN Money, ”Money that you invest in an annuity grows tax-deferred. When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.” Not having to pay taxes while the money grows can potentially benefit those who own annuities.

Annuities Aren’t Liquid

The fact that annuities aren’t liquid investments is considered a con by some investors. Excluding immediate annuities, the annuitant may not be able to access their money, including their principle, until they reach a certain age—or another predetermined event—at which point they can begin to receive payments. This means that annuities may not be suitable for short-term investments or investors seeking immediate access to their money.

Annuities are not flexible investments, as the contract’s terms and conditions are predetermined and cannot be changed. Annuity contracts usually come with early surrender penalties, which means that if the annuitant decides to withdraw the funds before the end of the agreement, they will incur a penalty. Per CNN Money, the surrender penalty “can start at around 7% if you pull out in the first year you own the annuity, and then it typically declines by one percentage point a year until it disappears after seven or eight years. You also will have to pay income tax on all the investment earnings in your annuity, and if you are younger than 59 ½ you typically will be hit with a 10% early withdrawal penalty courtesy of the IRS.” The fact that you may be subject to penalty fees such as these can make annuities unappealing to some investors.

However, some annuity contracts may have free withdrawal policies where you can get a portion of your money out without a surrender charge. If this is an important feature to you, make sure to seek an annuity that includes this benefit.

Perhaps one of the biggest benefits of opting for an annuity is that they can potentially provide a guaranteed income stream for life, which can benefit retirees looking for a steady source of income. Of course, this isn’t the case with every type of annuity, so be sure to talk to your financial advisor to find out if the annuity you’re interested in provides this benefit.

Annuities Can Sometimes Be Misleadingly Marketed or Sold as Safe Investments

All investments come with risk, and some are significantly riskier than others. If someone is telling you different, that is a red flag, both for the product and the advice-giver. Before making any investment decision, conduct due diligence on the product and make sure it aligns with your financial goals and risk tolerance. There’s likely something on the market, whether it’s an annuity or not, that will align with your needs.

One incredibly important point to make is that annuities should be a portion of your retirement portfolio—not your only source of income. Overall, we recommend maintaining a diversified portfolio to mitigate risk—and annuities can be part of that plan

Takeaway

When deciding whether to invest in an annuity, it’s important to consider all the pros and cons. Annuities can be a great way to ensure financial stability in retirement, but they can also be risky, complicated investments. Investors need to research and ensure they understand all the terms and conditions associated with the annuity before investing. It’s also essential to be certain that you’re working with a reputable financial institution and that you’re comfortable with the fees associated with the annuity. As always, a financial professional can help you wade through these waters and provide clarity on how you might achieve your financial goals.

Standard Disclosure

This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated. The information contained within is believed to be from reliable sources. However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors.  This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals.

Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered.

Investment advisory services are offered through Liberty Wealth Management, LLC (“LWM”), DBA Liberty Group, an SEC-registered investment adviser.  For additional information on LWM or its investment professionals, please visit www.adviserinfo.sec.gov  or contact us directly at 411 30th Street, 2nd Floor, Oakland, CA  94609, T: 510-658-1880, F: 510-658-1886,  www.libertygroupllc.com. Registration with the U.S. Securities and Exchange Commission or any state securities authority does not imply a certain level of skill or training.