When Barbara Feldman of Kendall retired from the Miami-Dade County Public School System after 44 years in December, she received her retirement funds in a lump sum. She and her husband, Steven, a certified public accountant, reviewed investment options for the money. They decided on annuities.
“Because it was her retirement funds, she wanted a safety net with the least risk possible,” Steven Feldman, 63, said. “We wanted principal preservation.”
Annuities, an investment wrapped in an insurance policy, can offer guarantees — such as a steady income stream for a certain period of time — that are attractive to investors who want a stable income during retirement. But those guarantees cost money, and the fees that accompany annuities are often a turn-off to investors and financial advisors.
Here’s how an annuity works: you buy an annuity for a lump sum, and then it makes payments to you over time. But there are a lot of choices. Your annuity payments can be immediate or deferred. Payment rates can be fixed or variable. Your payment period can be for a set number of years, or for a lifetime. Earnings are tax-deferred, but because annuities are designed as a retirement tool, withdrawals before 59 1/2 will be subject to a 10 percent IRS penalty.
Philip Herzberg, a Miami certified financial planner and president of the Financial Planning Association of Miami, said annuities can be confusing because it’s a complex product.
“There are a lot of variables. There are different flavors and types that have evolved over the years, but there are basically two components: it’s an investment wrapped around an insurance contract,” he said.
Feldman said they bought two deferred, fixed-rate annuities that will mature in 10 years. “I still work … but I wanted to build a plan for cash flow for when I retire,” he said. “Our primary focus was for safety, not for growth. We can’t afford to lose this principal. It’s a substantial amount of money for us.”
Feldman said they looked at the pros and cons, including high “surrender charges,” or early withdrawal penalties, they would incur if they took out the money in the first seven years.
“We looked at the options and decided what was right for us,” he said. “There are a million variables when it comes to annuities. You have to know what’s right for you.”
Feldman’s advisor, Dan Tasciotti, a certified financial planner with Tasciotti Financial in Miami, said annuities can be a prudent investment in the right circumstances.
“If you’re looking for guaranteed income for the rest of your life, than an annuity may be right for you,” he said.
On the other hand, Ana Cela Harris, a certified financial planner and estate attorney with Cela Advisors in Miami, said she recommends annuities for very few clients. She said she doesn’t like the lack of transparency in the fee structure.
“Fees just eat away so much of the returns,” she said. “And with an annuity, you’re locked in. I like flexibility. I’d rather have a choice. If you commit to an annuity, you don’t have a choice.”
Harris said there are a couple of scenarios in which an annuity could work. For risk-averse clients with modest means, an annuity can supplement Social Security payments and supply a steady income stream, she said. “It can work for people who want to ‘set it and forget it,’” Harris said. High-income clients who want to protect income from creditors, such as a doctor who wants to protect personal assets in the event of a malpractice claim, also can benefit from an annuity.
“But it goes against my investment philosophy of ‘you can’t control the market, but you can control your expenses,’” Harris said.
A 65-year-old woman with a pension, Social Security and savings could benefit from the guaranteed income an annuity could provide, Tasciotti said. “If she invested savings on her own, there is risk, because you don’t know what the return will be,” Tasciotti said. “I would recommend an immediate annuity for some of the money, not the whole sum, because you need some liquidity,” he said.
For a couple in their 50s who are not looking for immediate income but to accumulate money, an annuity may or may not work, Tasciotti said. “This is where you get into trouble with annuities because the annuity may have features that they don’t need,” he said. “You have to ask them ‘Do they like the idea of guaranteed income?’ Or are there other qualities of an annuity that are attractive to them?”
An annuity could fit into the big picture, but “the only time I would recommend an annuity to a 50-year-old couple is if the benefits were worth the costs,” Tasciotti said.
Annuities have no annual contribution limit, which can make annuities attractive for wealthy clients who have met their contribution limits for IRAs and 401(k)s, Herzberg said. “If you’re going to have it in there for the long haul, you can put a large amount of money in there tax-deferred,” he said.
Tasciotti said annuities have features that you can pay extra for that tailor them to specific needs. For example, one doctor client with a poor family medical history liked an annuity feature that waived the surrender charge if he went into a nursing home.
“To him, that was money well spent,” Tasciotti said. “It gave him peace of mind.”
Harris offers a different opinion. “People will pay extra for flexibility, but you don’t have to pay extra. Go to another product in the universe of investments.”
There is often a sales commission with an annuity, plus an annual annuity fee and maintenance fees. “Even if you get a no-load annuity, there are maintenance fees,” Harris said. “It’s hard to get a grasp on the fees.”
Tasciotti said the fees are the price you pay for guaranteed payments or guaranteed income for life. “There’s no free lunch. If you want a deferred annuity with guaranteed income, there are costs,” he said. “If I want those kinds of promises, then somebody has to be paid to do the work.”
Surrender charges are an early-withdrawal penalty imposed if you take out money in your annuity early. “Most people who come to me are shocked to learn there are surrender charges,” Harris said. “They think it’s going to be like a CD and just pay the interest.” Typical surrender charges are 7 percent for the first one to three years, then decrease one percent a year until they reach zero.
Feldman said he accepted the surrender charges because “we’re basically saying ‘We’re not going to touch that money because we’ve got it locked in,’” he said. “We’re not going to say next year ‘We need that money.’ We’re not going on a European cruise. We don’t have any big expenses planned, and if for some reason we do need access to money, we’ll get it elsewhere.”
Tasciotti said if you compare an annuity with a mutual fund, an annuity may have higher fees, “but an annuity has features that a mutual fund doesn’t have,” he said. “To say that they have higher fees is not fair. They have features that cost more than other investment vehicles.”
People can misunderstand what the guarantees are, particularly in newer, deferred annuities that base their payments on an equity index, Tasciotti said. “There is no way to know what your income will be,” he said. Annuities make up about 20 percent of Tasciotti’s business, and he prefers a fixed annuity. “It has no moving parts. There’s not much to misunderstand.”
Equity-indexed products also have a lot of variables, Tasciotti said. For example, if you have a $100,000 annuity that pays up to 8 percent, you may think that you will get $8,000 a year. “But the contract may say 8 percent of 90 percent of the money, which is $7,200. There are a lot of caveats,” he said.
During the recent economic downturn, companies like The Hartford and Allmerica Financial got into financial trouble for offering variable annuities with a guaranteed minimum payment, Tasciotti said. When times were good, all was well, but when interest rates dropped, they had trouble meeting their financial obligations, he said. Most companies have stopped selling that type of product, Tasciotti said.
Use a company that’s reputable and has strong financial reserves, he advises.
Annuities do offer a vehicle to defer taxes on gains, but clients have to be careful if they are choosing this investment solely to save on taxes, Tasciotti said.
“They are paying for features with an annuity that may or may not be appropriate for them,” he said. “You don’t just buy them for tax deferral. If you’re not going to use the other benefits that you’re paying for, you might have been better off just paying the taxes.”
Herzberg said an annuity is best “if you expect to leave it for at least 10 or 15 years. It will usually take it this long for the tax-deferred earnings to outweigh the higher fees and ordinary tax rate.”
Affluent clients who are experiencing higher tax rates can put a large chunk of money in an annuity, and take advantage of tax-deferred growth for a longer period of time. It could be an advantage, Herzberg said.
Harris said if a client has maxed out their 401k, IRA and Health Savings Account but still has money they would like to shelter earnings on, she would choose a Municipal Bond, because earnings are tax free.
Annuity payments are taxed as ordinary income, at your highest income tax rate. This can be a disadvantage when compared with other investments, Harris said. Capital gains are taxed at a lower rate.
The sales brochure may be full of disclaimers, so it’s best to read the annuity contract in entirety before you enter one, Harris said. And it won’t be easy.
Harris cites a 42-page contract she recently reviewed for a client. “How can the average person read a 42-page contract and understand all the fees? Who is supposed to calculate it? I’m an attorney, and I have trouble getting through the contracts,” she said.
For example, a deferred annuity with a fixed payment of 3.5 percent may use that rate in the accumulation phase, but a lesser one in the pay-out phase, Harris said. “Be sure to review the contract to make sure you understand the rules,” she said. “Don’t invest in things you don’t understand.”
Tasciotti said to consult an advisor to find the right tool for the job. “Annuities can be a good tool in the right circumstances, but an expensive tool if used in the wrong circumstances,” he said.