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Good, Bad & Ugly: Annuities

Welcome to a new series covering financial products. So, my intention here is to do a recurring set of articles in which I cover various financial services and products. In each post, I’ll spend some time unpacking the different elements of each product and provide some examples as to what can make that particular product or service good, bad or ugly.

In this first installment, I thought it might be good to cover a topic I mentioned in a recent post dealing with retirement savings for W-2 employees - the annuity.

What is an annuity

For our purposes here, there are two main types of annuities - immediate and deferred. An immediate annuity is a income payment stream, normally from an insurance company (or state lottery, lucky you!) to an individual. A deferred annuity is a savings vehicle where the investor does not pay taxes along the way - a feature called “tax-deferral”. We'll spend the majority of this post covering deferred annuities.

The tax-deferred nature of annuities can make them an attractive place to save additional funds for retirement. I say retirement because, unless you meet certain exceptions, you must hold annuity funds until age 59 1/2 before distributing.

Tax-deferred growth provides superior accumulation as compared to taxable growth because the money you would otherwise send to the IRS continues to earn interest and, ultimately, provides you with a bigger pot at the end.

There are three main versions of “deferred” annuities: fixed, indexed and variable. Basically, a fixed contract simply pays a fixed amount of interest per year, while an indexed contract pays a rate determined by the performance of an index, commonly the S&P 500. A variable annuity invests directly into mutual fund-like investments and is a security; that is, the value can move up or down.

A unique feature of any annuity is the ability to create an income stream or payout to the investor. The income stream normally comes from either an immediate annuity or the "annuitization" (beginning structured income payments) of a deferred annuity.

Most often, a retiree will use an annuity income stream to provide a guaranteed, lifetime income which they cannot outlive. This is something I'm going to dive in deeper with in an upcoming series of articles; integrating an annuity income stream into your retirement income planning can substantially increase both your overall odds of success and amount of income received.

When should you use an annuity

Most annuities are sold on a commission basis and, as an unfortunate consequence, they are often recommended for investors at times when they might not actually be the best option. Many retirement advisors who are employed by an insurance company are incentivized heavily to recommend annuity type products, often with bonuses and lavish trips.

There is nothing wrong with sales or commissions, and I certainly don’t wish to put down the entire concept. There are plenty of situations where annuities can hit it out of the park, commissions or no. Some examples:

  1. You’re a high income retirement investor who has maxed out your employer-provided retirement plans and is seeking additional venues for tax-deferred growth.

  2. You are a near-future or recent retiree who is looking to balance his retirement income plan with a guaranteed payout.

  3. You wish to create your own pension-like income.

  4. You want to hedge your longevity risk.

I will address the proper use & integration of annuities into a retirement income plan in future articles. Suffice it to say that if you arrange it properly, an annuity can significantly reduce risks & increase overall income levels during the retirement income life cycle.

What is a bad annuity?

This is a big ole’ can-o-worms because there are a multitude of factors which can make a an annuity bad or inappropriate for a certain individual. It’s one of those really great financial advisor answers where we say “it depends”. In general, we want to avoid:

High Fees

We’re talking about variable annuities here. Many variable annuities have total annual account fees of more than 3-4% annually. Some of the common fees:

- Mortality & Expense: ranging from .75% to 2% per year

- Optional Riders: ranging from .25% to 1.75% per year

- Investment Management Fees: ranging from .2% to 2.2% per year

The insurance company does a very good job separating these fees and burying them in the contract language, so its tough for a consumer to determine what they’re actually paying per annum.

I have personally reviewed annuities with total annual fees over 5%. This is just plain ugly and, well, I’ll leave it at that.

Surrender Charges

Most annuities come with a “surrender charge” period. What this means is that you’ll have a penalty if you choose to cancel the account within a certain period of years. Typically, depending on the features offered in the account, this period of time ranges from 5-15 years. Obviously, the longer the surrender charge period is, the less liquid your account is. We want as short a period as we can get.

Short Reinvestment Windows

This is a big "gotcha" provision that I see fairly often in annuity products. After satisfying your multi-year surrender charge period, some annuity carriers only give you a short window to make a decision on what to do with your money. Some times this is as little as 30 days. If you don't do anything, they will "re-up" you into a new surrender charge schedule. Since financial disorganization is a huge problem for many families, too many annuity purchasers will fail to see this time coming and inadvertently get locked in to another multi-year period of surrender charges. Shameful.

Limited Investment Selection

Just dealing with variable annuities again here: many have limited menus of investments, and often those menus are chock full of “proprietary” funds. For example, if you simply wanted a passive indexed fund (which are typically very cheap to buy) you may be forced to use the insurance company’s version of that fund at a much higher cost as compared to its peers.

Poor Company Track Record

This one affects mainly fixed and indexed annuities. Many of those products have moving parts which the insurance company can adjust after the contract starts, such as the second-year fixed rate or the “cap” rate on an indexed product. Unfortunately, what we’ll see with these products is that the company will offer a juicy “teaser” rate for the first year, and then make the contract less favorable as time goes on. Of course, since you’re locked in with surrender charges, they can do this and safely predict that you won’t leave.

Expensive Riders

Many annuities come bundled with additional options or “riders” as termed in the industry. While some of these riders do provide value and are appropriate in certain situations, the optioning of many of these riders is akin to the closing of a new car purchase. You know, the meeting with the finance person where they try to load you up on extra warranties and paint protection.

A rider that’s commonly bundled with annuities today is an “income rider”. This is a slightly confusing rider which has created more than a few misunderstandings regarding how the annuity actually works. Basically, the insurance company will guarantee a high “interest rate” (yes, quotations needed) on the income value of your account.

In effect, the insurance company is creating a “shadow account” for income purposes only. You can’t actually call the company and get that money in a lump sum; you must start structured income payments. The investor can only get the benefit of that higher rate if they choose to create an income stream from that annuity and with that company.

The rider can be fairly expensive - typically 1-1.5% per year - and is normally coupled with low-growth annuity products so that the actual net growth of the real account value is very low (and sometimes negative).

Again, this is just one example and there actually are good uses for an income rider. As with anything in the financial world, it completely depends on the individual situation of the client. I am singling out this rider because it is sometimes added (at significant cost) in situations where its simply not needed or inappropriate.

What is a good annuity?

When we say a particular annuity is “good” as compared to its peers, its normally because its missing some things. A good annuity will have:

- No (or short) surrender charge schedules

- Less fees, low fees and/or flat fees

- Easy to understand riders, or none at all

So, a good deferred annuity is one which is straightforward and without many of the extra frills.

A good variable annuity will often be low or flat-fee, and offer a broad array of investment choices which are often identical to the investments available in a regular brokerage account. Since purchasers of this type of annuity are normally aiming for tax-deferred growth, the low fees & investment selection are critical to success. We don’t so much care about the riders here.

It’s harder to find a commission-free Indexed annuity, but there are a couple out there. These fee-based indexed annuities normally offer higher caps (read: growth potential) than their commission-based counterparts. They typically don’t have riders available, but again for folks aiming for lower-risk tax-deferred accumulation, we don’t really care about the riders.


An annuity is simply another financial tool in our arsenal. They have some really great uses and the potential to drastically improve the retirement income life phase of an investor, if implemented properly.

It largely comes down to who’s helping you. If you’re talking to someone marketing insurance company products, you’re most likely dealing with a commission-based annuity. Now, they’re not all bad. Your likelihood of picking a good apple from that tree is much lower, but it can be done. In my opinion, you’re much better off starting with an independent, fee based advisor who is not beholden to a specific insurance carrier relationship.

As always, I’d love to connect with you and review your individual situation. The advice in this article is intended to be very general, and may or may not apply to your personal financial situation.

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