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Annuity Myths and Mistakes

Certified Safe Money Admin

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Annuity Myths and Mistakes – Top Annuity Myths to Avoid

Annuities can provide you with a steady and reliable cash flow stream in retirement – and with the lifetime income option, your payments will last for as long as you need them to. But annuities can also be somewhat confusing financial vehicles, and because of that, investors and financial advisors alike may not realize all of the potential benefits and pitfalls. So, it is important to know the top annuity myths to avoid so that you don’t get lulled into a false sense of financial security.

Myth #1: Annuities have high fees.

Are annuities safe? One of the biggest myths about annuities is that they all carry high fees. But this isn’t necessarily true. Although you will usually incur a surrender penalty if you withdraw your money from a fixed or fixed indexed annuity during the surrender period, these annuities won’t generally reduce your contribution to pay a sales commission. So, 100% of your money can go to work right away.

On the other hand, investors oftentimes will incur fees with a variable annuity. These charges can include:

  • Mortality and Expense (M&E) fees
  • Administrative fees
  • Annual management fees on the underlying investments 
  • Rider fees (if various optional benefits are added to the annuity)

It is also important to keep in mind that other types of investments and insurance products typically charge some type of fees. For instance, stocks and mutual funds generally pay a sales commission to the agent or broker who sold the product – and in many cases, this will reduce the amount of money you have going to work for you. 

In addition, just like all annuities can vary from product to product, and insurance company to insurance company, the fees that are charged can differ, too. Therefore, be sure to shop around before you commit to the purchase of any annuity so that you’ll know what to anticipate.

Myth #2: The insurance company keeps all of the money when an annuitant dies.

This myth will also depend on the type of annuity you have and the income payout option that you have chosen. For example, in most instances, if the annuitant (i.e., the person on whose life the annuity is based) dies, the remaining balance in the account will usually be paid out as a death benefit to a named beneficiary. With some annuities, a death benefit is automatically included, and with others, it may have to be purchased as an additional rider.

If, however, you have an annuity with a life-only payout (i.e., where the income stream continues for the remainder of your lifetime), then any remaining sum will typically stay with the insurance company. If you live a nice long life, though, you could end up receiving back much more money than you contributed to the annuity.

Myth #3: Fixed annuities offer extremely low-interest rates.

Because your principal remains safe in a fixed annuity, the “tradeoff” can be a lower rate of return. But there are other options for keeping your capital safe while at the same time having the opportunity to generate a higher return. This can occur with a fixed indexed annuity.

Fixed indexed annuities, or FIAs, are a type of fixed annuity that bases its return largely on an underlying market index, such as the S&P 500. When the market index performs well in contract years, the annuity is credited with a positive return – usually up to a set maximum or cap.

But, in contract years where the index performs poorly, there is no loss of principal. Rather, the annuity is credited with a guaranteed minimum which typically ranges between 0% and 2%. When the index performs in the positive again, the account value can build upon previous gains without having to first make up for any losses. 

Plus, as with other types of annuities, the account’s funds grow on a tax-deferred basis. So, no tax is due on the gains until the time of withdrawal. This tax-advantaged feature can allow the returns to grow and compound exponentially over time.

Taxable versus Tax-Deferred

Taxable Tax-Deferred
Initial Investment / Contribution $100,000 $100,000
Number of Years Invested 20 20
Before Tax Return 5% 5%
Marginal Tax Bracket 35% 35%
After Tax Return $189,584 $265,330
Future Account Value $189,584 $207,464

(Note that the after-tax figure does not take into account the possible change in tax bracket that may occur due to a lump-sum distribution of the taxable amount, nor any possible early withdrawal penalties that could be incurred).

Myth #4: A portfolio drawdown strategy offers more reliable – and higher – retirement income than an annuity.

While there are many retirement income “strategies” that could generate income in retirement, the only ones that offer a guaranteed lifetime income stream are defined benefit pensions, Social Security, and annuities.

Because the stock market is so unpredictable, income that is generated through equities can be extremely volatile – and in some cases, companies may reduce, or even eliminate, their dividends.

On the other hand, fixed-rate investments like bonds and CDs may provide you with a more stable income stream, but eventually, your money will have to be reinvested, and you could end up with a much lower rate in the future. 

Today, because people are living longer lives (on average), retirement income may need to be stretched out for 20 or more years. Longevity is often referred to as a multiplier of all other financial risks because you have to face those risks for a longer period of time. 

But an annuity can promise you a lifetime income stream, regardless of how long you need it, and no matter what happens in the stock market – or even in the overall economy. Without having to worry about whether or not income will arrive, retirees can focus on other things, like travel, entertainment, and spending time with friends and loved ones.

Myth #5: Annuities should only be purchased for the income they provide.

Although annuities can certainly provide a reliable source of income, not everyone purchases them for income-related purposes. These flexible financial vehicles can provide a number of other benefits, including:

  • Tax-deferred growth
  • Protection of principal
  • Funding for long-term care needs 
  • Legacy planning options

Many investors who have already “maxed out” their annual contributions with their IRAs (Individual Retirement Accounts) and employer-sponsored retirement plans will turn to annuities for additional tax-advantaged growth.  

Myth #6: All annuities work the same way.

While all annuities share some similar characteristics, not all annuities work the same way. There are actually several different types that are available in the annuity marketplace today. These include:

  • Fixed Annuities
  • Fixed Indexed Annuities
  • Variable Annuities
  • Multi-year Guarantee Annuities (MYGAs)
  • Single-Premium Immediate Annuities (SPIAs)

An annuity can be either immediate or deferred. With an immediate annuity, in return for a lump-sum contribution (such as a rollover from an employer-sponsored retirement plan), income will begin right away – or within 12 months of purchasing the annuity.

However, a deferred annuity won’t pay out income until a time in the future (and some investors never opt to turn the income stream on). During the accumulation period, funds in the annuity can grow tax-deferred, meaning that there is no tax due on the gain until the time of withdrawal.

Annuities are further broken down by how they generate a return. For instance, a fixed annuity provides a set rate of return that is declared by the insurance company. A fixed indexed annuity also offers a fixed account option, but some or all of the funds can generate a return that is based on an underlying market index. This, in turn, provides the opportunity for added growth.

A multi-year guarantee annuity, or MYGA, is a type of fixed annuity that provides a stated rate of return for a certain time period, such as 3, 5, 7, or 10 years. Once that time has elapsed, the annuity owner will usually have the option to either re-invest at then-current rates for a set period of time or alternatively to withdraw all of the funds penalty-free. 

With a variable annuity, the return is determined based on the performance of underlying investments like mutual funds. In this case, there is an opportunity to generate a significant amount of growth. However, owners of variable annuities can also take on risk because if the market drops, there is a chance that losses will be incurred.

Myth #7: You should only purchase an annuity if you are retired.

Although annuities can be appealing to retirees due to their income-generating capabilities, younger investors can also obtain a long list of benefits by purchasing an annuity. For instance, annuities can offer a way to continue saving and investing on a tax-advantaged basis, even if IRAs and retirement plans have reached the maximum annual contribution limit(s).

In addition, fixed and fixed indexed annuities offer guaranteed interest rates without risking any principal to stock market losses. Today, annuities can offer a myriad of other features, too, such as penalty-free access to funds for a terminal illness or long-term care needs. These features can be particularly beneficial for those who already have a health condition and may not be able to qualify for a stand-alone long-term care insurance policy.

How to Choose the Best Annuity

Everyone’s short- and long-term investment and income needs are different, so no single financial vehicle is right for all investors and retirees across the board. In addition, because all annuities are not exactly the same, even if an annuity would fit well in your portfolio, it is imperative that you choose the right annuity for your specific goals and objectives.

Because there are so many different annuity options, it can help to first discuss your financial objectives, risk tolerance, and time horizon with a retirement income specialist who can then determine whether or not an annuity would be a good fit – and if so, which type of annuity is best.

We can help you better understand how annuities work and dispel any additional myths about annuities so that you have a good understanding of how these products work and what you can (and can’t) anticipate you opt to purchase one.

Find the most credible, highest-rated Safe Money advisors in your area.

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