5 annuity mistakes to avoid: Expert guide to protecting your retirement
Creating stability is an important goal for most retirees. Americans approaching retirement have various tools they can use to achieve that goal, from well-stocked 401(k) plans to CD ladders. Often, these retirement vehicles are used to establish a steady stream of income.
Purchasing an annuity is an increasingly popular way to build a steady stream of income. While a helpful tool, one of the most common pitfalls of annuities is not understanding how they work. Without due diligence, it’s possible to lose thousands of dollars thanks to a simple mistake. Purchasing an annuity, assuming they work like a CD or mutual fund, can leave you prone to substantial loss. Before buying an annuity, it’s essential to know how they work and what goal you want to accomplish.
This guide details five common annuity mistakes to avoid, so you don’t risk outliving your resources in retirement.
What are annuities, and why do they matter for retirement?
An annuity is a contract between an insurance company and the purchaser. The purchaser deposits money into the annuity during the accumulation phase and may later receive income payments during the distribution phase.
Annuities can be helpful for retirement planning because they can help create a dependable income, but that comes at a cost and often carries restrictions. Despite the potential cost, the income can potentially be helpful for individuals who don’t have a sizable 401(k) or traditional pension, as the annuity can supplement Social Security income.
It’s important to remember that there are multiple types of annuities, including fixed, fixed-index, variable, and immediate.
Here is a quick summary of each type of annuity:
Like other investments, they all have their respective risks and benefits. Knowing what you’re purchasing an annuity for is vital. “Every annuity must serve a specific purpose. There must be a ‘reason’ for the purchase, and the client must agree that the annuity solves a specific problem. It’s either protection and compound interest accumulation with tax deferral, or a specific income target,” says Philip Gallant, CLTC®, managing partner of The Optimus Group, LLC.
Another feature that makes annuities attractive is their ability to act as a buffer to volatility. Some annuity funds can be less sensitive to market swings, which can be helpful for retirees using the annuity as income, but it’s important not to overinvest in an annuity for retirement.
Mistake #1: Not understanding contract terms and features
One of the more common annuity mistakes is failing to realize you’re entering into a contract. It’s easy to believe the salesperson’s pitch and to assume that illustrations or projections are guarantees.
Most annuities have several sections to know about during the purchase process, including:
Surrender schedule: The surrender schedule is the period during which you’re locked into the contract. If you opt to take funds out, you may incur a surrender charge, which is highest at the beginning and decreases each year.
Liquidity terms: Many annuities allow holders to withdraw a certain percentage without a surrender charge. The amount is often 10% of the value. There may be special provisions, such as confinement or terminal illness.
Crediting terms: These apply especially to fixed annuities and relate to how gains are calculated. Ask how the company credits gains, whether there’s a cap, and what happens in flat or negative years.
Income rider terms: If applicable, these apply to contract rules for optional add-ons such as guaranteed income. This can come with various fees and withdrawal limits that may limit what you receive over the years.
Misunderstanding any of these sections can leave you on the hook for tens of thousands of dollars. “When I go through annuity contracts, the first pages I review in slow motion are the surrender schedule, the income rider terms and conditions, and the crediting formula language,” says Eric Croak, CFP®, president at Croak Capital.
Using the free look period is helpful for determining whether the annuity is for you if you still have questions about the contract. The free look period varies by state, with all states offering at least ten days from receipt of the annuity to review the contract and decide whether to keep it.
Mistake #2: Overlooking fee structures and total costs
Fees aren’t inherently bad, but not understanding how they apply to annuities can be significant. Many annuities carry multiple fees, including:
- Mortality and expense charges
- Administrative fees
- Underlying investment fees
- Rider fees
That’s not to mention possible caps or spreads that limit upside that can also feel like a fee. Miscalculating a 2% fee difference, for example, on $100,000 over 20 years can result in $44,000 lost.
If you truly intend to use the income feature and don’t mind the charge, it can be a valuable trade-off. However, if you’re purchasing a rider for peace of mind, it pays to determine if the cost is worth it.
Ask the salesperson for the complete disclosure when considering an annuity so you can know all the costs you may incur, and don’t be afraid to ask questions if you have them.
Gallant concurs on the importance of understanding fee structures. “The two biggest fees are income and death benefit rider fees. They have a substantial impact on cash value balances, and when I am using an income rider with a fee, I make certain that the need is for income and that there is an actual advantage to using a specific product with an income rider. I will often tell the client that the cash value balance is an added benefit in the early years, but if they think they will need to draw money from the annuity rather than just counting on the income rider, I will not write that product. Fees destroy cash accumulation. The only benefit to an income rider in most cases is to take advantage of the roll-up balance and any bonuses for a significant period of time,” adds Gallant.
Mistake #3: Choosing the wrong annuity type for your goals
Knowing the why behind an investment is always essential to consider before purchasing. Annuities are no different. One common annuity pitfall that hinders many is not understanding the different types of annuities and that they aren’t all alike.
The four annuity types are:
Fixed: These are best for people seeking stability and a bond or CD-like contract.
Variable: Best for growth-minded investors, with stock market exposure in the contract.
Fixed indexed: These offer a balanced approach, typically combining downside protection with limits on upside returns.
Immediate: Immediate annuities typically pay out within a year but limit liquidity.
It’s important to determine your overall goals first when deciding on an annuity. Consider your entire retirement portfolio and what your risk tolerance is before deciding on a contract. A trustworthy salesperson will help you with this, too. “We anchor to the decision of which annuity to consider through cash flow timing, volatility tolerance, and preference for simplicity,” says Croak.
You can also speak with your financial advisor to determine if an annuity is a fit.
Mistake #4: Ignoring surrender charges and liquidity limitations
Many annuities allow for a free withdrawal of 10% of the contract value annually. The feature is an effective way to manage income needs in retirement, but withdrawing more or surrendering can have ruinous effects on your annuity, thanks to surrender charges.
Surrender charges typically range from seven to 10% for up to ten years, with the highest charges in the first several years of the contract. It’s key to understanding the withdrawal rules before purchasing, as they vary, and beware of annuities that lack clarity on withdrawal restrictions.
“In my experience, surrender charge schedules sting the worst when someone makes a major life change early on in the contract term. A seven-year surrender schedule with a 7% penalty can really box someone in if they need liquidity three years into the contract. In real dollar terms, a $50,000 withdrawal could have a $3,500 penalty in the bank immediately. Flexibility clauses are often much more important than headline rates. Liquidity does not come for free,” notes Croak.
Having access to a fully funded emergency fund is a wise way to avoid having to withdraw substantial funds from your annuity. If you have those funds in a high-yield savings account, you can usually withdraw them risk-free.
Mistake #5: Failing to shop around and compare offers
Comparison shopping is important with any major purchase, especially an annuity. Annuities may seem similar, and you may even find two that have the same labels. That doesn’t mean they operate the same.
Two products marketed as the same may have different surrender schedules, crediting methods, rider costs, and more. The differences may lead one to offer substantially more value. That’s not to mention differences in fees, crediting methods, and potential outcomes between similar annuity contracts.
It’s best to compare at least three providers to uncover the right one for you. Ask yourself questions as you compare providers, such as:
- What is the surrender period?
- What is the free withdrawal amount and year-by-year penalty?
- How is interest credited, and what limits apply?
- What are the total annual costs?
- What happens in flat and/or strong market years?
You may also want to consider using an independent agent rather than a captive agent. An independent agent can sell annuities from various life insurance carriers, reducing the chance of a commission-driven recommendation.
The best annuity is the one that addresses your specific situation with the fewest unwanted trade-offs.
How to choose the right annuity
Purchasing an annuity is an important decision and one that requires a thoughtful approach. Identifying the purchase reason is vital to selecting the right contract for you.
Regardless of your goal, it’s wise to focus on three areas: your retirement goals, your risk tolerance, and your income gaps. An annuity can help you address each area, but it will come at a cost. The goal is to meet your retirement objectives while minimizing unnecessary costs and restrictions.
Additionally, it’s wise not to overinvest in an annuity. An annuity can be a part of a well-rounded retirement portfolio, but putting too much capital into an annuity can expose you to unintended risks. Don’t overlook working with an independent advisor to receive unbiased help with your decision-making.
Bottom line: Avoid costly annuity mistakes
Annuities can be a valuable part of a balanced retirement portfolio when used wisely. Annuities can also come with fees, restrictions, and trade-offs that may affect your retirement goals if you don’t fully understand them.
Thoroughly reviewing a contract is essential to finding the right annuity to fit your retirement planning needs. Using an annuity calculator can be a helpful tool to help you unlock what kind of annuity is right for you and what kind of payments you can expect to receive in retirement.
