Why Do Financial Advisors Hate Annuities?

Financial advisors often hold varied perspectives on annuities, contracts typically offered by insurance companies. Annuities are designed to convert a sum of money into a stream of payments, often for retirement income. The complexity inherent in annuities, encompassing their benefits, costs, and tax treatments, frequently leads to diverse opinions within the advisory community. Understanding these nuances is important for anyone seeking clarity on why these financial tools are viewed differently by professionals.

What Annuities Are

An annuity is a contract between an individual and an insurance company where the individual makes payments and receives regular disbursements, usually starting at a future date. Its primary function is to provide a steady income stream, particularly during retirement. Annuities fall into three main categories: fixed, variable, and indexed.

A fixed annuity offers a guaranteed interest rate for a specific period, providing predictable growth and income payments. Variable annuities allow the policyholder to invest in various sub-accounts, with returns tied to the performance of these underlying investments. Indexed annuities, sometimes called fixed indexed annuities, offer returns based on a market index, such as the S&P 500, while also providing some principal protection. Each type serves different objectives, influencing their suitability for various financial plans.

Advisor Compensation Models

The compensation structure of a financial advisor significantly influences their recommendations, including their stance on annuities. Two primary models define how advisors earn income: commission-based and fee-only. Understanding these models helps consumers assess potential conflicts of interest.

Commission-based advisors earn a percentage of the products they sell, such as annuities, mutual funds, or insurance policies. An advisor receives compensation directly from the insurance company when a client purchases an annuity. This model can create an incentive to recommend products that offer higher commissions, rather than the most suitable option for the client’s financial situation. Commissions on annuities can range from 1% to 10% of the total value, which is factored into the annuity contract.

In contrast, fee-only advisors are compensated directly by their clients for advice, typically through a percentage of assets under management, a flat fee, or an hourly rate. This compensation model aims to align the advisor’s interests more closely with the client’s financial well-being, as their income is not tied to selling specific products. Fee-only advisors often operate under a fiduciary standard, which legally obligates them to act in their clients’ best interests, reducing potential conflicts of interest.

Annuity Features Driving Advisor Skepticism

Several inherent features of annuities contribute to financial advisors’ skepticism, primarily due to concerns about their impact on client liquidity, overall returns, and transparency. One significant concern is surrender charges, penalties imposed if an annuity owner withdraws funds or cancels the contract before a specified period, known as the surrender period, typically ranging from 3 to 10 years. These charges can be substantial, often starting at 7% to 10% of the amount withdrawn in the first year and gradually decreasing over the surrender period. Many annuity contracts, however, allow for penalty-free withdrawals of up to 10% of the account value each year.

Beyond surrender charges, annuities often involve complex fee structures that can reduce a client’s net returns. These may include administrative fees, typically ranging from 0.15% to 0.3% of the annuity’s value annually. Variable annuities, in particular, may also carry mortality and expense (M&E) fees, which compensate the insurance company for guarantees like death benefits or guaranteed income for life. These M&E fees generally range from 0.5% to 2% of the contract value each year. Additionally, variable annuities often have investment management fees for their underlying sub-accounts, which can range from 0.06% to 3% annually. Optional riders, which provide enhanced benefits such as guaranteed lifetime income or long-term care, also come with additional annual costs, typically between 0.25% to 1% of the annuity’s value.

The illiquidity imposed by surrender periods can be a significant drawback, making it difficult for clients to access their funds without incurring penalties. Furthermore, the tax treatment of annuities can be a point of concern. While annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawn, withdrawals are generally taxed as ordinary income, not at potentially lower capital gains rates. If withdrawals are made before age 59½, they may also be subject to an additional 10% IRS penalty, on top of ordinary income tax. For non-qualified annuities funded with after-tax dollars, the Internal Revenue Service (IRS) applies a “last-in, first-out” (LIFO) rule, meaning earnings are considered withdrawn first and are fully taxable until all earnings are exhausted.

Considering Annuities in Financial Planning

Despite the common reservations among some financial advisors, annuities can serve specific, valuable roles within a comprehensive financial plan for certain individuals. One primary scenario where annuities are considered is for providing guaranteed lifetime income, addressing the concern of outliving retirement savings. This feature is particularly attractive for individuals seeking a predictable and steady income stream that can supplement Social Security and pension benefits.

Annuities can also be a consideration for those who have maximized contributions to traditional tax-advantaged retirement accounts, such as 401(k)s and IRAs, and are looking for additional avenues for tax-deferred growth. The ability for investments to grow without annual taxation until withdrawal can be beneficial for long-term wealth accumulation. While not suitable for every investor, annuities can align with the needs of individuals prioritizing income security and tax-efficient growth beyond conventional retirement vehicles.

Steps for Evaluating an Annuity

For individuals considering an annuity, a thorough evaluation process is essential to ensure the product aligns with their financial goals and risk tolerance. Review all fees and charges associated with the annuity, including administrative fees, mortality and expense fees, and any costs for riders. Understanding the surrender schedule and its implications for accessing funds is also important. These details are typically outlined in the annuity contract and prospectus.

Comparing multiple annuity products from various insurance providers can help identify the most competitive terms and features. It is also advisable to research the financial strength ratings of the issuing insurance company, as these ratings reflect the insurer’s ability to meet its future financial obligations. Consulting with a financial advisor, particularly one who operates on a fee-only basis, can provide unbiased guidance and help navigate the complexities of annuity contracts, ensuring an informed decision.