What You Must Know About Annuities

Editor's Note: This story comes from Wealthramp.

There’s an inside joke within the financial services industry in which advisors quip, “Annuities are never bought, they’re sold.” It’s another way of saying, annuities are an easy sell to consumers who know nothing about them.

Consumers hear it this way: “Beware the salesman offering too-good-to-be-true solutions for securing a comfortable retirement.”

The reason there’s so much said and written about annuities is because they are confusing, and insurance companies invest billions to tout only the benefits.

Essential tips on annuities

Spoiler alert: Annuities are not the golden ticket they’re made out to be, because when you peek behind the curtain, you’ll find a lot of legal fine print that restricts access to your funds and fees that will make you wish you had taken time to read the contract carefully.

Still, annuities may be a useful tool under certain circumstances.

Let’s then delve into the world of annuities, exploring what they are and why they may not be the right fit for everyone.

Fact: Annuities are not investments

Annuities, in their simplest form, are contracts sold by insurance agents (or advisors who have licenses to sell insurance).

And we know the insurance industry has a pervasive marketing presence. But annuities are not securities, therefore are not investments.

There may be instances in which entering into a contract with an insurance company could make sense.

The problem is since annuities are often presented as a be-all solution to your financial problems, consumers rarely take the time to make sure the annuity is the right option.

Instead, they often wind up with buyer’s remorse after a period of time with no chance of getting their money back because they just didn’t read the fine print.

Fixed and variable annuities

There are literally thousands of different annuity offerings out there, but we can put them into two main categories that dominate the market: fixed annuities and variable annuities.

Fixed annuities are the most straightforward, offering a guaranteed interest rate over a specific period.

Variable annuities introduce complexity because they advertise the potential for earning higher returns by investing in a selection of underlying assets, such as stocks and bonds.

So just like any other stock investments, these returns are not guaranteed and will fluctuate as the market goes up and down.

Here comes the fine print

First and foremost, these are slickly packaged, complex financial products that are laden with fees, surrender charges and potential hidden costs that can eat into your returns.

These fees are not adequately disclosed upfront, leading many investors to learn the true cost only after they have committed to the annuity.

For example, fixed-indexed annuities generally earn the agents and brokers who sell them a 4% commission or more. And yes, you’re paying it.

An often illiquid investment

Moreover, annuities are often illiquid investments, meaning your money may be tied up for a long period, blocking access to your funds when you need them most.

You’ll likely get hit with surrender charges, which can be significant, if you decide to withdraw your money before a certain predetermined period, typically ranging from five to 10 years.

Furthermore, annuities, like traditional retirement accounts like 401(k)s and IRAs, offer tax-deferred growth but not the same tax advantages.

When you withdraw money from an annuity, your earnings will be subject to ordinary income tax rates, which could be higher than the capital gains tax rates applied to investments held in taxable accounts.

Younger investors: Be extra skeptical

Older investors are not the only targets of annuity marketing. For younger investors, annuities are pushed as a tax deferral investment program.

But the reality is the most efficient way to invest in a tax efficient portfolio of stocks is by maxing out their 401(k)s and Roth IRAs.

Generally, younger investors don’t benefit from annuities when they can potentially get higher returns offered by a number of other investment vehicles like inexpensive ETFs and index funds.

Again, an annuity is not a growth investment.

Here’s when an annuity does make sense

Despite the pitfalls and complexities of annuities, it is essential to remember that annuities are not inherently bad. They are simply financial tools that can serve specific purposes under certain circumstances.

Just like any tool, their usefulness depends on how and when they are applied.

One instance where annuities might make sense is for risk-averse individuals nearing retirement, seeking a guaranteed income stream to cover essential expenses during their golden years.

Plus, not all annuities come with exorbitant fees and hidden costs. Some low-fee annuities exist, offering a more transparent and cost-effective option for potential annuity buyers.

Some financial advisors may offer “no-load” annuities. Which means they may not have any upfront fees, but they often do have surrender charges that you just need to account for.

So again, be careful.

How to figure out if an annuity is right for you

Go into the decision knowing the appeal of buying an annuity may be more emotional than practical.

The marketing is focused on the sense of security they provide, and who doesn’t want a financially secure retirement? It’s particularly appealing to risk-averse investors approaching retirement.

Annuities are the furthest thing from being a simple solution for retirement planning. That means you should never sign an insurance contract without knowing what’s in it. Remember, these are contracts written by the insurance company’s attorneys.

If you do want to consult an advisor about whether an annuity might work for you, seek out an advisor who will be knowledgeable and unbiased. In other words, a fee-only advisor who doesn’t sell insurance.

A truly qualified advisor can help you determine if an annuity really does suit your financial needs or if alternative solutions might be more appropriate and less restrictive.