Do Annuities Have Any Downsides?
I don’t think I’d go as far as to say that annuities have downsides. There are however some features that people should be aware of before making the decision to purchase. In this article, we give an in depth explanation of all those “drawback” features and how to plan for them accordingly.
Fees
Fixed annuities come with small maintenance fees no different from what you’d see in cds and bonds, usually well below 1%. Variable annuities are the ones that critics rave about when they say annuities have outrageous fees. I’m not recommending that kind of annuity to you today.
Commissions
Speaking of fees, lets talk about commissions, which is what we get paid by the insurer when someone buys from us. It is no more and no less expensive to buy from an agent as opposed to going direct to the insurance company. The carrier doesn’t take money out of your policy to pay us. They pay us as affiliates and ambassadors of their products.
In Deferred Annuities Only, Before You Start Receiving Income, Participation Rates, Caps, and Policy Fees Can Be Changed At The Discretion of the Insurer
Slight changes in your policy can occur in Deferred Annuities before you start receiving income. The fact that the insurance company can change things at any time is often brought up by detractors. While this may be true, and only before you elect to receive income, the changes are typically negligible and set up so that the insurance carrier can serve more clients and make good on their guarantees. These insurance carriers base the Cost of insurance on a prediction of mortality rates and market conditions.
So what exactly is changing, if the carrier opts to change anything at all? Participation rates, fees, and cap rates. Fees are charged monthly on your account and are less than 1 percent (usually .50 or .25) of your account value. This is no different than what you’d find with other retirement accounts. If your annuity is inside of a qualified plan, there are no fees on top of what you’d pay in the retirement plan. Cap rates are found in indexed annuities and set a limit on the upside of your policy for market gains. If the market is up 10 percent, and your cap is 7 percent, you receive 7 percent interest credited to your account value.
Participation rates apply to indexed annuities and are a percentage of the market gain and how much you’ll receive. The annuities we currently work with at Bluecrushinsurance.com offer 100 percent participation rates. For example’s sake, say you have an 80 percent participation rate. If the stock market is up 10 percent, you receive 8 percent, subject to your cap. If your cap is 7 percent in that scenario, you’d still receive 7 percent. With the same 7 percent cap, if the market is up 5 percent, you’d receive 4 percent credit interest in your policy. If the market is down, you don’t lose anything, or you get credited whatever the minimum rate is in your policy.
They may lower these rates and fees or raise them depending on their projection and predictions of how many people are going to die and at what ages, as well as market performance. Take for example the 0-3 percent floor guarantee or income for life guarantee. To keep that alive, if the market becomes extremely volatile for too long a period of time (hasn’t happened yet) or if a projection looks grim, they reserve the right to slightly change fees, participation rates and cap rates.
Again, they make these changes so that they can make good on their guarantees and pay out claims when they are due. These changes are not always negative. Many times they lower fees and increase cap rates. The carriers are inclined to remain competitive so that they can continue to sell policies. If word gets out that they’re not servicing their clients properly, they go out of business. They know this and are very unlikely to make changes out of greed.
Annuities Are Insured By State Guaranty Funds, Not The FDIC
Annuities aren’t FDIC insured, but each state has an insurance guaranty association (GA) that backs up insurance company policies in the event of the insurance company’s bankruptcy. Your state’s GA is funded by making assessments on every insurance company that currently does business in your state. These collections pay for the obligations of failed insurance companies that your state’s GA has accepted.
Nonetheless, no one wants to be in the position where they have to get their funds from a guaranty association as their account values may have superseded the limits that the GA will pay out. That’s why you go with an A-rated company and keep tabs on them so you can switch out before things go south. These things tend to have a whole bunch of warning signs before they collapse.
10 percent penalty before age 59 and half plus surrender charges. Taxes on earnings (If Not In a Roth IRA).
Deferred qualified annuities have a 10 percent penalty and tax on withdrawals (both earnings and principal) before the age of 59 and a half. Deferred non-qualified annuities have a 10 percent penalty and tax on the earnings, not the principal, on any withdrawals before the age of 59 and a half. Immediate annuities don’t suffer the 10 percent tax because IRC Section 72(u)(4)(C) states that “immediate annuity” means an annuity “which provides for a series of substantially equal periodic payments during the annuity period”. This means that single premium immediate annuity payout options of life only, life with a period certain guarantee, and even a period certain only option, should qualify for this immediate annuity exception to the 10% penalty tax rule.
Annuities also come with a surrender charge if you pull money out during the surrender period, which is usually 10 years. That charge starts at about 10 percent and goes down incrementally every year by about 1 percent point until it reaches zero. Now if a withdrawal is made before age 59 and a half during this surrender period, and this is a tax advantaged annuity inside a Roth IRA, the surrender charge is on top of the 10 percent penalty and taxes you’d pay.
There is one small exception to the surrender charge. At the beginning of the second contract year, you can pull out 10 percent of the account value without surrender charges. However, in qualified annuities only, if you’re not 59 and a half or older, you’d still be subject to the 10 percent penalty and taxes. This also means if your risk tolerance changes and you want to switch to more risky accounts, you have to wait until the surrender charge period ends.
To Conclude
There you have it. All the good and bad of annuities. I’d say the good outweighs the bad by a long shot. Once you start receiving your guaranteed income for life, there’s nothing the insurance company can change to ruin your plan. You don’t have to worry about the changes anyway, if they happen at all, because they’re often negligible. If you’d like to purchase an annuity to see how they would work for you and your goals, put in a quote request.