Why Retirees Should Never Invest In Annuities

Let me start with a confession: I hate variable annuities.

Hate is a strong word, so let me rephrase: I despise them with an unholy passion.

To be fair, not all annuity reps are snake oil salesmen, and there can be specific situations where an annuity might make sense for a given investor. But by and large, annuities as retirement products are a lousy deal for investors.  Let me explain why.

The sales loads are often outrageous

It’s often joked that hedge funds, with their 2% management fees and 20% performance-based fees, are less an investment vehicle and more a compensation scheme for the manager. Well, you can make the same criticism of annuities.  While sales loads have mostly disappeared on most stock and mutual fund orders as the industry has moved to an RIA fee-based model, they are alive and well in the world of annuities. In addition to the management fees you generally pay on the underlying investment funds and the assorted administrative and insurance costs, you also usually pay a sales load that can be 7% or higher.

If you’re “lucky,” the load will come in the form of a surrender charge that eventually falls to zero. But this generally means that you’re trapped in the product for 7-10 years.  There are some annuity issuers out there, such as pioneer Jefferson National, that have no sales charges and have very reasonable internal expenses. But these tend to be the exception and not the rule.

The tax benefits are overrated

If you are still in the accumulation phase (i.e. still contributing new savings), then variable annuities offer a modest amount of tax relief. Your dividends, interests and any realized capital gains are tax free until you begin taking distributions after age 59½.

But here’s where it gets sticky. Annuity withdrawals are taxed on a last in, first out (“LIFO”) basis. It’s probably easiest to explain this by using an example. Let’s say you invest an initial $100,000 and it grows to $150,000 by the time you decide to retire. If you take a lump-sum distribution, you pay regular income tax on the first $50,000 you take out. No taxes would be due on the remaining $100,000, as this is simply a return of principal. If you annuitize and take monthly payments, a formula is applied in which a portion of the payment is considered taxable income and a portion is considered a non-taxable return of capital.

That sounds good, right?

Well, if that is where the story stopped, I’d say that the tax benefits were great. Unfortunately, there is more.

When you die and pass your assets on to your heirs, there is generally a step-up in basis. Your heirs get to start fresh with a cost basis at current market levels.

Not so with annuity products. Your non-spouse heirs will have to pay taxes on all of those accumulated earnings.

If you annuitize in retirement, you generally forego the ability to give an inheritance or fund a charity.

If you decide to annuitize, or convert your nest egg into a lifetime guaranteed income stream, you have a degree of retirement security. You know what your payout is going to be, and it doesn’t depend on stock market returns or changes in bond yields.

Again, this sounds good. But there are a couple points to consider. First off, the payouts aren’t all that great these days. A lifetime guaranteed  payout for a 60-year-old man offers an annual cash flow of between 4%-6% at current rates.

Sure, that’s better than what you’ll find in an investment-grade bond ladder or in a portfolio of blue-chip dividend-paying stocks. But once you die, the principal belongs to the insurance company. You have no ability to leave an inheritance to your heirs or a bequest to your church or favorite charity.

Personally, I’d prefer to take my chances with a portfolio of dividend paying stocks. The immediate payout is smaller, but dividends generally grow over time, and the principal remains mine to do with as I please. If, in my senile old age, I decide to leave my entire fortune to a Brazilian go-go dancer in Copacabana, I would have the freedom to do so.

So, is there any scenario in which an annuity makes sense?

Maybe. Let’s say that you earn a high current income and that you’ve already maxed out your company’s 401k plan ($18,000 in 2015, or $24,000 for investors 50 and older). And let’s say that you’ve also already maxed out your IRA or Roth IRA contributions, if you qualify, and any other deferred comp plans your company might offer.

If you still have excess savings that you’d like to shield from high current taxes, a variable annuity is not the worst option, and it has the added benefit of having a layer of protection from lawsuits or creditors in most states.

But for most investors, it makes sense to simply invest their excess savings in tax-efficient mutual funds, ETFs or a basket of quality buy-and-hold stocks. Save yourself the fees and unnecessary complexity that comes with an investment in annuities.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog

22 Responses
  1. […] Are all brokers the degenerate trash portrayed in Wolf? No, of course not. But the brokerage model does incentivize a wanton disregard for the client. And it’s not just stocks. In fact, the commission model for stocks went out of fashion years ago, but unfortunately, it is alive and well in products like variable annuities (see “Why I Hate Annuities”). […]

  2. RMR

    Ok, you hate/despise all annuities. You are fee-only and this does not fit YOUR business model. You are no better than the commission guys, same song different verse! Maybe the annuity could be in someone’s best interests, hard to make a generalized statement without considering someone’s unique situation. By the way, variable annuities are available without commissions, surrender fees or insurance costs, a fact you probably know but hid because it ruined your self-serving message. Tell me where I am wrong…

    1. Had you actually read the article, you might have seen this line: “There are some annuity issuers out there, such as pioneer Jefferson National, that have no sales charges and have very reasonable internal expenses. But these tend to be the exception and not the rule.” I am a fan of Jefferson National’s model and consider them one of the “good guys” here. I also noted:

      “So, is there any scenario in which an annuity makes sense?

      “Maybe. Let’s say that you earn a high current income and that you’ve already maxed out your company’s 401k plan ($18,000 in 2015, or $24,000 for investors 50 and older). And let’s say that you’ve also already maxed out your IRA or Roth IRA contributions, if you qualify, and any other deferred comp plans your company might offer.

      “If you still have excess savings that you’d like to shield from high current taxes, a variable annuity is not the worst option, and it has the added benefit of having a layer of protection from lawsuits or creditors in most states.”

      Next time, read the article before commenting.

      CLS

      1. RAC Rider

        Just a thought. Next time someone trashes & bashes & misses part of the story, consider it an “opportunity” to strut your stuff in a humble way. Thank the reader for their time then Point out the missed info. “Without” being condescending. You may keep them as a reader. Sometimes a situation that is salvaged, yields the best customers &/or clients down the road.

        We are in the process of setting up another annuity, so we now have some new info to consider. Thank you for your info.
        RAC

        1. Bruce B

          What is wrong with an annuity that has an interest bearing account that varies with rates (currently in excess of 1.5%), a bundle of 5 star rated funds, that is NL/NS (no load no surrender) and permits your heirs upon your death to 1035 exchange it to themselves nicely facilitating their retirement planning while permitting you to withdraw and deposit at will?

  3. Arthur Kelly

    I would be interested in your comments on charitable remainder trusts. I could set up a trust which will pay as an annuity to my son and when he passes the remainder of the value goes to a charity I chose. I realize in monthly or quarterly payments would be less than an annuity of the same face value.

    artkelly281@comcast.net.

    1. Hi Art,

      A CRT can be a sound vehicle. It really just depends on what your needs and objectives are. If your goal is to provide income to your son for his life and then fund a charity, then you are doing exactly that. I should emphasize that annuities too can be a useful tool for estate and legacy planning. The problem is when they are sold with the advisor’s pay in mind rather than the client’s needs.

      Thanks,
      CLS

  4. The elderly father of a cousin had been taking margin loans on his brokerage account in order to meet expenses. The cousin asked me to look over the account and I noticed that there was a matured annuity that had sufficient cash value to meet those expenses and avoid interest charges. The broker tried, instead, to convince the 87 year old to get a new annuity, but I suppose that’s how Morgan and Stanley were able to get to where their corporate descendants have evolved.

  5. Neglected to mention that I bought an annuity about 30 years ago.

    I was tending to a facial traumatic injury to a kid in the Emergency Room and after being done and the mother effusively thanking me, she told me she would do me a favor. She quickly proceeded to try and sell me an annuity before I even finished giving post-operative care instructions. She did this right there and then in the Emergency Room.

    At the time, I think it was 2 AM, the deal sounded great and I signed on.

    I read the fine print over the next day or two and came to the realization that it was a horrible product and a poor match for me at that stage in my life. I cancelled within the 3 day grace period and never looked back.

    Needless to say, she wasn’t happy and decided to have her son’s post-operative care done elsewhere.

    1. “Do you a favor” by selling you a high-cost annuity…after you had just operated on her son. Wow. Well…I suppose you have to respect her chutzpah. I guess.

      That’s like standing up at a funeral to give a sales pitch for life insurance!

  6. Dan

    I only will recommend an annuity if its a long term investment. There are bad advisors just like bad hedge funds. They fit more needs than just the example you illustrate. A very conservative investor with no interest in holding long only stocks/funds could be interested in an VA that can protect downside mkt value while participating in the upside.If used as an income stream VA’s make sense for a portion of the portfolio. Your article is good but bias does exist.

    1. TallBill

      The secretary that he dictated the article to probably chose the wrong word when running the spell checker!