Investor Toolkit

Despite what you've heard, annuities aren't all bad

Key Points
  • Annuities, particularly variable annuities, are unpopular and getting more so every day. However, there are pros as well as cons to these much-maligned financial products, say advisors.
  • Some $2 trillion is currently invested in variable annuities.
  • Benefits of annuities include guaranteed income, protection against longevity risk and upside participation with downside protection.

It's not just investment analyst Ken Fisher who hates annuities. On the list of financial products that fiduciary advisors love to bash, annuities — particularly variable annuities — are somewhere near the top.

They are an easy target. The insurance contracts are expensive, difficult to understand (for both consumers and financial advisors), hard to get out of and arguably not in the interests of the millions of consumers who have bought them. Indeed, the sale of high-commission annuities has been flagged as one of the more egregious ways that financial advisors fail to act in their clients' best interests.

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Since the Department of Labor finalized its fiduciary rule (now in limbo) last year, annuity sales have fallen dramatically as brokerage firms and advisors anticipate that the products may not pass muster under a tighter regulatory standard.

"Companies have been canceling products left and right because they don't live up to the standard of meeting clients' best interests," said Ric Edelman, executive chairman and founder of Edelman Financial Services. Like many advisors, Edelman helps clients undertake tax-free Section 1035 transactions that allow consumers to switch out of high-cost annuity contracts into less costly ones. "With that exception, I never advise clients to purchase annuities," he said.

Most fee-based financial advisors regulated as fiduciaries appear to feel the same way. David Yeske, managing director of registered investment advisory firm Yeske Buie, said that variable annuities have fallen out of favor with the fee-based advisors he regularly surveys for the Financial Planning Association.

"The use of variable annuities has been declining for years, and that's probably representative of the fiduciary side of the advisory world," said Yeske.

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For his part, Yeske is not categorically against fixed or immediate annuities that guarantee income streams for investors, but he has never used them for his own clients. He thinks the adverse tax treatment of variable annuities — the gains in all distributions from the contracts are taxed as ordinary income — makes them a bad idea for savers.

"Variable annuities are a perfect machine for converting capital gains to ordinary income," he said. While the gains within a variable annuity portfolio are tax-deferred, they are ultimately taxed at up to 39.6 percent, versus the 15 percent capital gains tax rate. "It's hard to find scenarios where the benefits of tax deferral justify getting taxed at the higher rate."

Not all fiduciary financial advisors pan annuities, however. Harold Evensky, head of Evensky & Katz and a trailblazer in the RIA industry, believes that low-cost immediate annuities offered by companies such as Vanguard will be crucial for retirees at risk of outliving their assets.

Mark Cortazzo, senior partner of fee-based advisor Macro Consulting Group, thinks there are situations where annuity products are an effective solution for risk-averse consumers. While he has steered very few of his clients toward annuities recently, because of low interest rates and higher prices since the financial crisis, he thinks advisors who ignore all annuity offerings are failing their clients.

"We have to get past the rhetoric," said Cortazzo. "If you're a fiduciary and you don't consider annuity solutions, you're not doing your job."

There is currently about $2 trillion invested in variable annuity products alone, according to research firm Morningstar. With the oldest baby boomers now in retirement, those numbers may rise much higher. Like all investment product offerings, annuities have positive and negative aspects to them. Here are a few of the more prominent pros and cons.


Guaranteed income. In their simplest form, annuities guarantee an income stream for buyers either now (immediate annuities) or beginning at a later date (deferred annuities). While diversified investment portfolios have a potential for higher growth and cost far less to create, there is no guarantee that the assets will retain their value.

"Strategies to manage risk are not guarantees against catastrophes," said Cortazzo. "If a portfolio account goes to zero, the insurance company still keeps sending out the checks."

Protection against longevity risk. People are living longer and there's a good chance that many people will outlive their investment portfolios. What's more, retirees who are drawing on their investments to support themselves run a market "sequence of return risk."

In adverse markets, it can be very difficult to recover from losses if you're withdrawing from your account. Cortazzo points out that an investor who put $1 million into the at the beginning of 2000 and began taking $5,000 out per month ran out of money this year.

The use of variable annuities has been declining for years, and that's probably representative of the fiduciary side of the advisory world.
David Yeske
managing director of Yeske Buie

"If I'm drawing out 6 percent of my portfolio annually and the market drops 50 percent, I'm suddenly withdrawing 12 percent," said Cortazzo. "An annuity takes the sequence risk and the longevity risk off the table."

Market upside participation with downside protection. Variable annuity contracts offer the insurance component of an income guarantee with the possibility of increasing the payout if markets do well. Most of the products have a reset provision that allows payouts to increase if markets go up.

The terms of the contract reset to higher values but do not decrease if the market subsequently drops. Since the financial crisis, insurance companies have been paying customers billions to walk away from guarantees they priced prior to the crisis.


High cost. Annuity products can be expensive. Simple immediate annuities and deferred-income annuities generally have upfront commission rates that range from 1 percent to 4 percent. More complicated products, such as variable annuities and fixed index annuities, can have upfront commissions of 7 percent or more.

Between insurance charges (also called mortality and expense fees), underlying sub-account fees for variable contracts and administrative fees, overall annual costs can be more than 2 percent.

Hard to understand. While immediate annuities are easy enough to understand, more complicated variable annuity contracts or fixed index contracts that offer the potential for participation in market upside can get very complicated. Contract riders that offer additional benefits at additional costs make things more confusing still. Disclosures have improved but are still difficult to fathom.

Limited investment options. Variable annuity contracts limit the options you have for investing the portfolio. That can handicap your ability to grow the account and your payouts. The fees charged for the underlying investments — usually mutual funds — can be high.

Surrender penalties. Annuities are long-term contracts, and it can be very costly to break the terms of the deal. Buyers of annuities have to wait until they are 59½ years old before they can withdraw money without a 10 percent penalty.

They also have to wait six, eight or even 10 years after entering the contract before they can withdraw money from the account without additional surrender charges. The surrender charge period typically mirrors the commission level on the product: the higher the commission, the longer the surrender penalty period. While many insurers now offer contract terms that will allow for early withdrawals from annuities without surrender penalties, it will cost you up front.

Tax hit. While the investment gains in a variable annuity are tax-deferred, when the money is eventually withdrawn, the gains are taxed as ordinary income, not capital gains. For most people, that will result in a bigger tax hit. Withdrawals that are not part of a planned annuitization of the account per the terms of the contract will also be fully taxed as ordinary income until all the gains from the portfolio are distributed. Normally, annuity payments are comprised of taxable gains and non-taxable return of the principal invested.

— By Andrew Osterland, special to