The “Cons” of Annuities and How to Get Out of Them

“Annuities are not bought, they’re sold.”

Anyone who has seriously considered a wide range of investment options have come across this tagline. And surely, you’ve heard the counter-slogan “There are no bad investment products, just bad uses for them.”

When you ask your brokerage firm, bank, or insurance company for reasons why an annuity might be in your best interest, what typically happens next? They either provide you with a quick summary emphasizing the advantages of annuities, or they bedazzle you with the instrument’s complexities–a convoluted labyrinth of information requiring a tour guide (the agent) to walk you through what they (or perhaps you too) want to see.

It’s not that annuities don’t present advantages, it’s just that for every advantage it presents, there is an equal or greater disadvantage.

First, annuities are highly complex instruments, often blending actuarial calculations into a convoluted host of investment options. It is also important to note that many of the agents who sell annuities don’t even understand how they work!

Yes, the people selling you on the benefits of these instruments have no clue as to the detailed workings of their own product.

Aside from this fact, the most notable disadvantages that may noticeably and significantly impact you are the expenses–often notoriously high–and the illiquidity.

Investopedia lists just a few of the cons to consider (do your homework…there is plenty more).

Hefty Fees – The biggest concern with annuities is their cost compared to mutual funds and CDs. Many are sold through agents, whose commission you pay through a considerable upfront sales charge. Direct-sold products, which you buy straight from the insurer, can help you get around that big upfront fee. But even then you could be faced with sizable annual expenses, often in excess of 2%. That would be high even for an actively managed mutual fund. And if you take out special riders to increase your coverage, you’ll be paying even more.

Lack of Liquidity – Many annuities come with a surrender fee, which you incur if  you try to take a withdrawal within the first few years of your contract. Typically, the surrender period lasts between six to eight years, although they’re sometimes even longer. These fees can be on the large side, so it’s hard to back out of a contract once you sign on the dotted line.

Higher Tax Rates – Issuers often cite the tax-deferred status of your interest and investment gains as a main selling point. But when you do take withdrawals, any net returns you received are taxed as ordinary income. Depending on your tax bracket, that could be a lot higher than the capital gains tax rate. If you’re young, you’ll probably be better offer maximizing your 401(k) plan or individual retirement account (IRA) before putting money into a variable annuity.

Complexity – One of the cardinal rules of investing is not to buy a product you don’t understand. Annuities are no exception. The insurance market has exploded over the past few years with a slew of new, often exotic variations on the annuity. Some, like the equity-indexed annuity, come with fees and limitations so complex that few investors fully understand what they’re getting into.

So how can you get out of your annuity and into something more favorable–perhaps into an investment that you can actually understand?

Here are a few pointers:

  1. If you’ve “been sold” an annuity and have buyer’s remorse, you may be able to terminate the policy and avoid the surrender change if you are still within your “free look” grace period. Grace periods vary by insurer and state, typically with a time frame of 10 to 30 days post purchase.
  1. If you are decades away from age 59 ½ and your annuity has not accumulated sizeable gains, you will not get dinged too badly by taxes, as they apply only to gains in the annuity. You still might have to pay a surrender charge, but if it’s nominal, it might be worth paying the price to avoid having your money tied up for decades.
  1. If your annuity has significantly appreciated and you want to avoid a tax time bomb, you may be able to annuitize the product, transitioning your annuity (whether fixed, variable, or equity indexed) into an income stream. Your tax hit will be reduced, considering that distributions are a balanced proportion combining both principal and gains.
  1. If you are past your free-look grace period yet far from your surrender period, you might have a few limited options. Several annuities offer a yearly withdrawal option that is “surrender-free.” This opportunity is usually available each contract year, the year starting from the date you signed your annuity contract.
  1. You may have the option to take up to 20% of your money out of the contract each year without having to pay a penalty. But bear in mind the tax implications of the surrender. Nevertheless, this option allows you to reduce your annuity without paying a whopping surrender charge.
  1. If your annuity is part of an individual retirement account or Roth IRA, you might be able to transfer your entire balance surrender-free to another IRA as a trustee-to-trustee transfer and defer the tax.
  1. If you are subject to a surrender charge, you may transfer your penalty-free withdrawals to another non-annuity IRA without having to pay tax.

Rule of thumb: don’t invest in a product that you cannot understand, especially if it’s going to tie up your money for decades!

As for points 6 and 7 above, where you choose to put your money is ultimately up to you and your investment goals.

Typically, investors who value sound assets look for the following characteristics: diversification, insurance, control over assets, growth potential, and tax advantages. And many investors have found that a gold and silver IRA matches those characteristics–characteristics that define “sound investment.” Why not build your nest egg with history’s most robust economic insurance policy?

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