Why You Should Avoid Annuities in Your Financial Plan

Annuities are financial contracts offered by insurance companies, generally structured to provide a stream of income, often for retirement. Individuals typically exchange a lump sum or a series of payments for future income distributions. While these products can offer a predictable income stream, understanding their structural and financial considerations is important before committing to such a long-term arrangement.

Product Complexity and Variations

Annuities encompass a broad range of products, each with distinct features regarding contributions, growth, and payout. Fixed annuities offer a guaranteed minimum interest rate and provide fixed periodic payments, often appealing to those seeking predictability and lower risk. Money in a fixed annuity accumulates interest at rates set by the insurance company, similar to a certificate of deposit (CD).

Variable annuities allow the owner to invest in various subaccounts, similar to mutual funds, where payments fluctuate based on the performance of these underlying investments. This structure means the account value and future payments can increase or decrease with market performance, introducing more risk but also potential for higher returns. Indexed annuities link returns to a market index, such as the S&P 500, while typically protecting the principal from market losses.

Annuities are also categorized by when income payments begin. Immediate annuities are purchased with a single lump sum and start providing income within one year of purchase, suitable for those needing prompt cash flow. Deferred annuities have an accumulation phase where money grows tax-deferred before income payments commence at a future date. The variety of these contracts, along with numerous riders and guarantees, can make selecting and comprehending a specific annuity challenging for many individuals.

Financial Implications of Annuity Features

Annuity contracts often include various fees and charges that can impact overall returns and the amount of income received. Administrative fees cover costs such as record-keeping and customer service. Variable annuities often impose mortality and expense (M&E) fees, which compensate the insurer for assumed risks like guaranteed death benefits and lifetime income. Some annuities may also include investment management fees for underlying subaccounts, further reducing net returns.

A significant financial consequence is the surrender charge, a penalty for withdrawing funds early or canceling the contract before a specified period ends. Surrender charge periods commonly last between three and ten years, with the fee typically starting high in the first year and decreasing gradually. While many contracts allow penalty-free withdrawals of a small portion, exceeding this limit or fully surrendering the contract can result in substantial penalties. These charges are designed to recover the insurer’s upfront costs, including commissions paid to agents.

Investment Performance and Purchasing Power

Annuity returns can differ from other investment vehicles, and inflation can erode their purchasing power over time. Fixed annuities typically offer guaranteed interest rates, providing stability but often yielding lower returns compared to market-based investments. For indexed annuities, while they offer principal protection, their returns are often subject to caps, participation rates, or spread rates, which limit the extent to which the annuitant benefits from positive market performance. This means that even if the underlying index experiences substantial gains, the annuity’s credited interest may be considerably less.

Variable annuities, while offering market participation through their subaccounts, still involve various fees that can reduce net performance compared to direct investments. For many annuities, particularly those with fixed payments, inflation poses a notable risk to long-term financial security. The purchasing power of a fixed income stream diminishes as the cost of goods and services rises. While some annuities offer inflation-adjusted riders or cost-of-living adjustments (COLAs), these features typically result in lower initial payouts. The trade-off for potential inflation protection is a reduced starting income, and such adjustments may not fully keep pace with actual inflation rates.

Taxation of Annuity Distributions

The tax treatment of annuity income has specific rules that differ based on how the annuity was funded. Earnings within annuities grow tax-deferred, meaning taxes are not due until withdrawals or distributions begin. However, once money is distributed, the earnings are typically taxed as ordinary income, which can be a higher rate than capital gains rates applicable to other investments.

Annuities are categorized as either qualified or non-qualified for tax purposes. Qualified annuities are funded with pre-tax dollars, often through retirement accounts like traditional IRAs or 401(k)s. When distributions are taken from a qualified annuity, the entire amount, including both contributions and earnings, is taxed as ordinary income because none of it has been taxed previously. Non-qualified annuities, conversely, are funded with after-tax dollars. For these, only the earnings portion of distributions is taxed as ordinary income, as the original contributions have already been taxed. The Internal Revenue Service (IRS) generally applies a “last in, first out” (LIFO) rule to non-qualified annuity withdrawals, meaning earnings are considered to be withdrawn first and are fully taxable until all earnings are exhausted.

A significant penalty can apply to withdrawals taken before age 59½. Unless an exception applies, a 10% federal early withdrawal penalty is imposed on the taxable portion of the distribution, in addition to regular income taxes. This penalty underscores that annuities are intended for long-term retirement planning and not for short-term liquidity needs.

Reliance on Issuer Solvency

An annuity represents a contractual promise from an insurance company, meaning the security of future payments is directly tied to the financial strength and stability of the issuing insurer. Unlike bank deposits, which are insured by the Federal Deposit Insurance Corporation (FDIC), annuities are not federally insured. Evaluating the insurer’s ability to meet its long-term obligations is important for policyholders.

Independent rating agencies, such as A.M. Best, Standard & Poor’s (S&P), Moody’s, and Fitch, assess insurance companies’ financial health and claims-paying ability. These ratings consider factors like balance sheet strength, operating performance, and business profile. Higher ratings generally indicate a stronger capacity to fulfill contractual promises. Consumers can typically find an insurer’s financial strength ratings on the company’s website or through these rating agencies.

In the event an insurance company becomes insolvent, state guaranty associations provide a layer of protection for policyholders. All states have these associations, which operate by assessing other insurers to cover obligations of a failed company. However, this protection has limits, typically $250,000 in present value of annuity benefits per individual, though coverage amounts can vary by state. Payments from guaranty associations are not automatic and can involve delays, as they depend on court approval and the liquidation process of the insolvent insurer.