- November 27, 2019
- Posted by: Blake Fostvedt
- Category: Brokers, Financial Planning, Financial Planning and Investment Blog, Stocks, Wealth Management
Annuities are wrong for almost everyone. If you’re unfamiliar with annuities here’s the gist – you pay a lump sum now in return for a future income stream, usually for the rest of your life. Annuities are essentially the opposite of life insurance. Think of it as you vs the insurance company – in a life insurance contract you “win” if you die prematurely, in an annuity you “win” if you live longer than expected.
Annuities are such terrible investments that the minute the government passed a law specifying that financial professionals had to act in their client’s best interest, annuity sales fell off a cliff. The fiduciary rule was passed in 2016, annuity sales fell 8% that year and an additional 18% in the first quarter of 2017. However, that law was later shelved in 2017 and annuity sales have since rebounded.
Fixed vs Variable Annuities
Fixed annuities prevent losses and allow the investor to take part in some upside – though the upside is very limited – around 4%. Thus, if the market goes up 20% then the investor will only make 4%. However, if the market falls 20%, the investor will not lose any money. Variable annuities, on the other hand, are essentially a mutual fund type of account overlaid with a thin layer of insurance. Here are some of the reasons why I hate annuities:
If your circumstances change and you need money urgently, you are going to be charged if you’re still within the surrender period. A typical surrender period is seven years and the surrender charge starts at 7% and falls by 1% per year. If a client purchased a $200,000 contract and encounters a financial emergency the first year and needs to access their money, they could be charged $14,000 to do so.
Annuities pay extremely high commissions that can range from 6-10% of the total contract amount. If a client was sold a $200,000 contract, the salesperson might take home $16,000 upfront. This creates an inherent conflict of interest between the salesperson and the client.
Annuity fees are usually high – typically 2% per year and variable annuities can cost 3-4% per year. Furthermore, the funds that the variable annuities are invested in typically have underlying expense ratios of 1-2%. These fees eat away at investors’ returns; this is especially true for variable annuities.
If you purchase an annuity with after-tax dollars, annuities (compared to other investments) are very tax-inefficient. Gains associated with annuities are taxed as ordinary income, not capital gains. Using the 2019 tax rates, if you’re single and make $100,000/year and have an annuity with a $10,000 gain that you wish to sell, your gain will be taxed at a marginal tax rate of 24%. If you had instead purchased a piece of real estate, stock, bond, etc. that had the same gain you would only be taxed 15% (assuming at least a one year holding period).
If you purchased an annuity with after-tax dollars and pass away, whoever inherits the contract (that isn’t your spouse) will not receive a step-up in basis. If you would have invested the same money in a stock fund, your heirs would’ve benefited from a step-up in basis at the date of your death or 6 months later. This is an important estate planning tool. For example, if you have an annuity with a $50,000 gain that is passed to your child when you die, the children will be responsible for the $50,000 gain (and any subsequent gains) when they surrender the contract. On the other hand, if you had the same $50,000 gain in a stock fund, your children would receive a “step-up” in basis when you pass away and would only be taxed on gains moving forward.
Lack of Transparency
Annuity contracts can be very confusing and the majority of clients that I’ve helped do not understand the contract that they purchased. Annuities are complex instruments with many moving parts that aren’t always adequately explained by the seller. People who buy annuities often do not understand the fees, surrender charges, tax consequences, etc. and simply view these assets as “safe” investments.
If you’re interested in working with a fee-only wealth management advisor who will always act in your best interest – send me a direct message, call/text 402-515-3382 or email me at Blake@SuccessfulPortfolios.com.