Life Changes

Annuities: More cons than pros?

Tim Maurer, CFP, VP at the Financial Consulate
Izabela Habur | E+ | Getty Images

You've probably heard the following marketing balderdash thought up by someone promoting the sale of bad investments: "There are no bad investment products, just bad uses for them."    

While there are certainly inappropriate uses for good products, there are also investment products in existence that should never have been created and that, when combined with ignorance or self-deception, can have disastrous results. 

While every major branch of the financial services industry—banks, brokerage firms and insurance companies—are or have been the proprietors of bad products, there's little question that the product subheading of annuities under the insurance umbrella has attracted the most criticism. 

 They've even earned this  tagline: "Annuities are not bought, they're sold." 

While I'll admit the tagline was likely written in an effort to market an annuity alternative, it rings a great deal truer than the quote previously mentioned. You could also say that annuities are among the "most bought, least understood," financial products. So let's first define what an annuity is, and then run through the pros and cons.

(Read more: It's time to ponder your pension plans)

Types of annuities

Since the word annuity has generic applications outside of the investment universe, for the purposes of this article, an annuity is an investment product created by an insurance company. There are four primary varieties common in the marketplace: immediate annuities, fixed annuities, variable annuities and equity indexed (or just simply indexed) annuities.

Immediate annuity: a product in which you trade a lump sum of money for a stream of income from an insurance company. 

Fixed annuity: characteristics similar to those of a certificate of deposit (CD) with a bank, although the terms are typically longer. 

Variable annuity: characteristics similar to those of a mutual fund or mutual fund portfolio

Equity indexed annuity: in reality, a fixed annuity advertising gains indexed to the upside of equity markets without the downside. (If your too-good-to-be-true bells are going off, it's for good reason, but more on that in a moment.)

(Read more: Planning for retirement? Factor in Medicare costs)

While every major branch of the financial services industry—banks, brokerage firms and insurance companies—are or have been the proprietors of bad products, there's little question that the product subheading of annuities under the insurance umbrella has attracted the most criticism.
Tim Maurer
CFP, Financial Consulate VP

Annuity pros

Please don't mistake my cautionary language for blind condemnation of all annuity products. Annuities come with benefits that often cannot be duplicated in any other investment.  

Immediate annuities are, in my opinion, the most useful of the suite. For Americans who will not be retiring with a meaningful stream of pension income, immediate annuities offer that potential. Because an immediate annuity is purposefully consuming both interest and principal to create an income stream, the individual distributions are likely to be higher than anyone could justify taking from a balanced portfolio of investments, where maintenance of the principal balance is often the goal.

Fixed annuities allow an investor to lock in rates of return that are comparable to CDs, but likely for longer terms (whereas CDs are typically quoted in months, fixed annuities are quoted in years ranging from one to 10.) The most common are three, five and seven year fixed annuities.    If (read: when) interest rates rise from abnormally low rates to abnormally high rates, it could be a wise time to allocate some of one's fixed income exposure to a fixed annuity.

And unlike a CD—the interest from which is paid out and taxed annually—the interest or gains earned in annuities are deferred until distributions are taken.

Many annuities promise some level of principal protection. Even in certain variable products (invested in equities), a portion of your principal or even future income may be guaranteed by the company. 

The advantages of equity indexed annuities are, frankly, hard to find amidst the overly-simplistic marketing pledges shrouding their overly-complex underlying construction. ... Whoever sells you the policy will likely be going on a nice vacation soon—commissions on these products range into double-digit percentages. Additionally, you could suspend disbelief and allow yourself to think you're getting the upside of the market without any downside. Ignorance can be blissful, if only momentarily.

(Read more: How to cope with 'sudden wealth' inheritance)

Annuity cons

Unfortunately for each of the pros, there are pretty significant cons. At this time, prevailing interest rates (and correspondingly the rates used to calculate immediate annuity payouts) are so low that committing funds could expose you to a meaningful amount of inflation risk. So even if you're predisposed to lock in a more secure income stream with an immediate annuity, consider waiting until rates normalize. The same could be said for most fixed annuities.

The tax deferral of annuities is worth something, but there's a price—or prices, really—to be paid. All of your gains will be taxed at your ordinary income rate. Especially if you're investing in a variable annuity with equity exposure, you're trading the tax privilege of capital gains for a rate—deferred or not—that  could be twice as much.  

Another negative tax implication is the loss of a "step-up" in cost basis to your heirs. Capital assets that were purchased at a low cost—like stocks and real estate, for example—are afforded a step-up in their cost basis upon your death.

If you sold those assets during life, you'd paid capital gains tax.  If you gave them to your heirs while you were alive, your heirs would inherit your cost basis. But if you wait to pass them to heirs until after your death, they will receive a step-up in their basis to the cost of the holding on your date of death.  

Annuities with significant appreciation, however, receive no such benefit. In fact, not only will your heirs inherit your cost basis, they'll be paying tax at their ordinary income rate and may be forced to distribute the policy and take that gain in short order, resulting in a tax time bomb for those you hope to bless with an inheritance.

Getting to Know Annuities
Getting to Know Annuities

More cons?

While the guarantees in some annuities are comforting—even if they're only given by the company (not the FDIC)—you may pay dearly for them. Many annuities offer a cafeteria plan of shiny options, but each comes with a cost. The insurance on your investments is not free.  

My least favorite feature of annuities, however, is the illiquiditity.

First, you must be 59½ years of age to withdrawal the gains from an annuity without paying a tax on the gains and a 10 percent early withdrawal penalty. Second, because actuaries need time to make assumptions work and insurance companies need time to recoup the larger-than-average commissions to agents, most annuities tie your hands with a surrender charge—a meaningful reduction in your payout that usually descends over five, seven or even up to 15 years.

Finally, since you're paying for tax deferral by taking a tax hit upon distribution, many are afraid to take the money out, especially since annuities are taxed on a LIFO basis, which means that the gains (100 percent taxable) are distributed before the tax-free principal.

The bottom line: If you decide to purchase an annuity for any of their applicable uses, I recommend hunting for a low- or no-commission product with little-to-no surrender charge. This will help eliminate a couple of the most unfavorable qualities of these products. But even then, there may still be more cons than pros.  

 —By Tim Maurer, special to Tim Maurer, a certified financial planner, is vice president of Financial Consulate based in Hunt Valley, Md.