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Mike Palmer's December Kiplinger Column - Five Things Your Annuity Seller Won't Tell You

Most Annuities Are Sold, Not Bought. Here's What You Need to Know

Annuities are typically sold, not bought. In his December Kiplinger column Mike Palmer uncovers just a few of the things annuity sellers often gloss over when selling annuity products.   

The Annuity Tax Time Bomb

Annuities are often touted for their tax-deferral. Earnings in annuities are tax-deferred — but only while they are in the account. Once you take money out, any gain is taxed as ordinary income. That may be fine for you, but what about your beneficiaries?

Unlike marketable securities held in a taxable account, your heirs don’t get a step-up in cost basis on annuity assets at your death. Beneficiaries of annuities must pay ordinary income tax on gains and must commence annual distributions (based on their life expectancy) following your death. An investor who bought $500,000 in a S&P 500 ETF and saw it grow to $1 million would pass the entire $1 million to their heirs (assuming no estate tax). That same asset in an annuity would see only $880,000 going to heirs, assuming a 24% tax bracket (the $500,000 gain would be reduced by $120,000 because of income tax).

Annuity Contracts Are Complicated

A good rule of thumb is “the more complex the investment, the more likely it’s enriching someone other than the investor.” For example, fixed indexed annuity providers offer “point to point” crediting, and the investor can choose from multiple valuation points in time and the fees for each option differ. Then there are crediting caps, participation rates, buffers and floors that also impact the actual return on your annuity investment. Many annuity providers feature a menu of esoteric index options. One product I reviewed offered two “AI-powered” indexes, along with the S&P 500 FC Index.

How the contract credits returns can also be difficult to decipher. Some products offer “annual reset,” while others use a “high-water mark” method. Remember, most indexed annuities only calculate index returns based on the price movement, not any dividends. That means the historical annualized S&P 500 index return (about 10% over the last 50 years) gets reduced by about 2% to 3% when excluding dividends.

Annuity Riders Will Likely Make Money for the Advisor Than for You

Riders are “bells and whistles” that add features to a standard annuity — and they come at a cost. Here are just a few of the annuity riders I’ve come across, with the cost noted in parentheses:

  • Annual liquidity rider (.95%)
  • Strategy charge (1.25%)
  • Guaranteed minimum income benefit rider (1.4%)
  • Guaranteed death benefit rider (.35%)
  • Lifetime income rider (1.5%)

These riders reduce your credited return, which makes it imperative to analyze the cost vs the potential benefit. For example, if you purchased an annuity tied to the S&P 500 with a one-year point-to-point cap of 9% and added a 1% rider, your credited return in any one year would be 8%, even if the S&P 500 returned 12%.

Some Annuities Are Like Hotel California: You Can Check Out, But You Can Never Leave 

To paraphrase the Bard, parting is such expensive sorrow. Want to take your money out of the Athene Performance Elite 15 annuity? It will cost you 15% the first two years after purchase. And the surrender charges last for 15 years!

In addition, most annuities charge surrender fees not only to principal but to earnings as well. Annuities are among the most lucrative products a commission-compensated adviser can sell — so be sure to understand the seller’s motivation in their recommendation.

Trying to remove or control emotion in financial decisions is challenging. If you consider an annuity purchase, understand the risk you are transferring and its probability of occurring. Additionally, be sure to understand the specific features of the contract — don’t blindly accept a seller’s explanation.