Things to Consider Before Buying an Annuity

Buying an Annuity

For some individuals, annuities may play an important role in potentially increasing the odds of success of not outliving retirement income but we caution that it is important to thoroughly understand what you are buying and why you are buying it. All too often, it is easy for individuals and the advisors that serve them to be caught off guard by the perceived potential benefits of various annuities. Careful study should be done to understand your needs for income and legacy (what you leave behind) and then design investment strategies/products that seek to increase the odds of achieving those ends.

Below is a very high level summary on various types of annuities...They have been ranked from least complex to most complex (in our opinion).

  • Fixed Annuity. A fixed annuity is a contract between an insurance company and a customer, typically called the annuitant. The contract obligates the company to make a series of fixed annuity payments to the annuitant for the duration of the contract. A fixed annuity generally pays a stated rate of interest (i.e. 3% per year) for a stated term (i.e. 6 years). If you are familiar with CD’s you can almost think of this as a CD alternative, one of the major differences being that fixed annuities often pay slightly higher rates and offer tax deferred savings during the contract term. You are not taxed on the earnings of a fixed annuity each year unless you withdraw the money from the contract. CD’s are FDIC insured and offer a fixed rate of return if held to maturity. Annuities are not FDIC insured.
  • Single Premium Immediate Annuity (SPIA) - A SPIA may be a worthwhile consideration when trying to drive the highest level of income per dollar you sacrifice to the SPIA. When you place your money in a SPIA, your money is gone, for life! You will simply receive a recurring amount from the insurance company for the remainder of your life. If someone is recommending you place all of your money into a SPIA, you should question that recommendation. You also have an option of choosing a period certain attached to the lifetime payment which guarantees that the income payments continue for, for example 10 or 20 years, in the event of premature death. Some of the current SPIA offerings provide for limited access to principal in order to attract more investors since the idea of having absolutely no liquidity is not so desirable.
  • Fixed Index Annuity - These are perhaps the most popular products in recent years, being touted as a way to experience the upside of the stock market without the downside. Indexed Annuities are complex and not suitable for all investors. In general, we believe that these products are not materially favorable when compared against a fixed annuity in good markets, and worse yet, a poor alternative to a fixed annuity in poor performing markets. We will not go into the details of this product in this post but much attention is being placed on this segment of the annuity market to engineer more and more complex products.
  • Variable Annuity. Variable annuities are long term, tax-deferred investment vehicles designed for retirement purposes and contain both an investment and insurance component. They have fees and charges, including mortality and expense risk charges, administrative fees, and contract fees. They are sold only by prospectus. Some variable annuities might be considered less complex than others, particularly when their primary features are limited to tax deferred accumulation and ability to choose which investments to use out of the list of investment options. More than likely this is not the type you are interested in if you are looking for a guaranteed lifetime income stream. Guaranteed lifetime income riders are additional guarantee options that are available to an annuity and available at an additional cost. Many annuities sold by advisors/brokers are the annuities that have various riders that provide a lifetime income, some form of enhanced death benefit and, if you're lucky enough not to have your withdrawals and the cost of the product deplete your account value, then you may even have some residual account value down the road to provide to heirs. Due to the design and costs of these products, preserving principal over time might be more difficult. Variable Annuities are subject to market risk and may lose value.

LIQUIDITY RISK – Access to Your Money

All Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59 ½ are subject to 10% IRS penalty tax. Surrender charges apply. All guarantees are based on the claims paying ability of the issuing insurance company.

When you have money invested in stocks, bonds or cash, you have access to your money within a few days generally speaking. With an annuity, depending on what type you use, the access to your money may be very limited. On the extreme side, there is a SPIA as mentioned above. This is simply you exchanging a lump sum of money in exchange for ongoing income payments from the insurance company. In this case, your money is no longer yours the day you purchase the SPIA. On the flip side, with most other annuities, if you are over the age of 59 1/2, you can either take a penalty free withdrawal each year (ranging from 5% to 10%) if allowed and/or withdraw more money than that but be subject to what is called a surrender charge. This is a penalty cost that you would have to pay based on the terms of the contract.

Let’s say that you have a Fixed Annuity that pays 3% and is locked in for 5 years. They may have a penalty free withdrawal privilege of 5%, but say you need 10%. That additional amount needed would be subject to a penalty dictated by the terms of the contract.

If you want the most flexibility and liquidity then consider sticking with a diversified account of stock and bond investments designed specifically to pursue your goals for growth and income.

Stock investing involves risk including potential loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. 


Various products have features that can provide an income for life and even income for a surviving spouse, if a joint payout option is chosen. Most commonly these types of riders and features tend to be a part of Variable Annuities but they have made their way into the Fixed Index Annuity space in recent years as well. Each of these features costs extra money to provide. It is not uncommon to see annual costs of some variable annuities with all the bells and whistles cost upwards of 4% each year. So beware of the costs involved in order for an insurance company to guarantee “income for life.”


Outside of providing potential income for individuals, one of the primary selling points of many annuity products is showing people how they can avoid market risk - that is the ups and downs of the stock market. It is important, however, to truly consider what you might be giving up by not taking on market risk at all, so be careful with that line of thinking.

Fixed Annuities and SPIA’s have no stock market risk at all. They are in no way predicated on the performance of the stock market but may be impacted by the health of the insurance company itself. Fixed Index Annuities, however, provide some level of upside participation with a typical downside cap at 0%. This is where the story surrounding market upside with no downside comes in to play. It's not that simple though. 

We believe much of the potential benefit of these index products lie in their ability to maintain a relatively high cap rate (which is not sufficiently high in our opinion at this time). The cap rate is simply the maximum you will get should the stock market increase in value over a given period of time. So, let's say your cap rate is 5% and the stock market goes up get 5% minus any fees that may be part of your contract. If the stock market goes down 5% you make 0% and may be charged fees that may be part of your contract.

Contrast this with a fixed annuity that pays a set rate for a set term. This consistency can make a fixed annuity a more compelling investment as it pertains to generating a consistent return on your money year over year. Mathematically speaking, making 3% each and every year for 5 years may be a better fit for your risk tolerance and goals than making an uncertain set of returns that may not maximize the benefit from compounding interest.

Variable annuities have exposure to market risk through investing in various subaccounts (which act like mutual funds). Depending on the riders (and costs) associated with your contract, it may be tough to ever get ahead regardless of how you are invested. Many annuity companies even restrict how you can invest depending on what guarantees the insurance company is providing (like lifetime income). This makes this vehicle the most challenging when it comes to generating consistent returns or market like returns as so much of the control of the investments may be out of your hands anyway.

COSTAll products have a cost

All products have a cost, the question is can you see the cost or not. In most any investments we use with our clients, such as our managed account platform, the fee is transparent as clients pay it from the assets inside their investment accounts. When it comes to most annuity products, advisors/brokers are still paid on the product, and the benefits you receive, while likely satisfactory to you (otherwise you would not consider purchasing), may contain additional costs that reduce the theoretical benefit of each product. The costs are usually not as transparent and are represented by the spread that the insurance company collects not only to pay the person who sold the product, but also to make money for the firm offering the product in the first place.

BOTTOM LINESteps You Can Take to Make Better Decisions

Follow these steps before committing to a product you may not fully understand:

  • Know your goals for retirement income and desire to preserve assets for the next generation (if applicable)
  • Be realistic about your retirement spending (both early stage and late stage)
  • Be open to diversifying your money into products designed to help you in your efforts of meeting your financial goals.
  • Attempt to understand the inner-workings of the product you buy if it is complex (like fixed index annuities or variable annuities) or work with a professional who can explain all the details to you. Instead of solely relying what your advisor/broker is telling you about the product, request a complete fact sheet, an illustration showing hypothetical future values of your principal, and/or a full prospectus.
  • If you own a product you don't feel is right for you based on further study, don't be afraid to change course.

We suggest always getting professional advice before making any major moves that may result in a reduction in benefits or a possible penalty.

All too often individuals reaching retirement will say that they don't know how much money they need, they just want as much as they can get without invading principal. If you are one of those individuals who has been diligent enough to save adequate funds (or maintain a basic lifestyle) then by all means make principal preservation key. Otherwise, know that you saved the money for a reason. While much of your income may be earnings or interest, at times it may be necessary to invade principal, especially when unforeseen expenses arise such as repairing your roof or A/C at your home.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.