With annuities boasting one of the most lucrative commissions in the investment sales world, you can imagine why meals at the local eatery while listening to the pitch are "free." As a point of clarification, we don't sell annuities, or any insurance product and can't earn a commission of any type on anything.
But the free lunch ends at the local diner. There are situations for which an annuity provides a fine solution. One would be for a lottery payout. Another would be for a parent with a spendthrift adult child now being rationed. Still another would be a retiree with a savings cushion so slim that risk assets like stocks are unwise, but stocks inside an annuity might work well because the income is guaranteed even if the account exhausts itself. For the well-heeled, steer clear.
Annuities are often presented as being valuable by way of guarantees and tax deferral. But at what cost? There are two primary factors driving the disadvantages of annuities; high fees and high taxes. Traditional costs are problem number one. Annuity fees are often so high, they might consume the entirety of the original investment within a normal lifetime. And while there are cheap, no-commission annuities, don't expect to hear about those from your Big Bank Broker or agent. But the problems don't stop there. While taxes are deferred for a time, annuity earnings are always taxed at the highest applicable bracket: ordinary income. This is true of income withdrawn during one's lifetime and taxes on increased value when left to an heir. Contrast that with owning a stock until the end of one's life and then bequeathing it to an heir. The dividends earned during one's lifetime would be taxed at a maximum of 23.8% and the capital gain in the value of the stock would be forgiven at the owner's death, leaving your inheritor zero taxes owed. This tax forgiveness even applies to a surviving spouse. Stock portfolios can be constructed to defer tax on most gains with a tax-free cleansing of profits at the first and second deaths of a couple. Annuity tax deferral into an ordinary tax bracket of up to 38% seems onerous in comparison.
One of the most misunderstood components of many variable annuities occurs within those contracts containing an income benefit. The broker-speak used when explaining the accumulation details can lead to significant mismatches in what is said and what is heard. Because our brains are wired to hear information about returns as though we are earning interest, we think of returns in terms of credits to our account, like interest from a CD. A bank CD offering 2% is guaranteeing a credit of 2% plus your principal whether you take the income or the entire amount. When an annuity salesman says "it guarantees you 6%." It doesn't work the same way as a CD. That's because you are usually being guaranteed only a 6% higher withdrawal privilege; OF YOUR OWN MONEY. They say "It credits you 6% Mr. Jones, in any year that you don't take income." YES, BUT IT'S FUNNY MONEY. They are merely crediting you a larger withdrawal benefit of your own money, and they are charging separate fees for that privilege and based on the set of books that provides the largest fee. That combination virtually assures the principal goes to the insurance company over time and the rationing is calculated so that you die before they are on the hook with a zero balance and income still due.
