[My December article for ACEP NOW is all about annuities, particularly their downsides, since those are generally much more significant than their upsides. It was blandly titled, “Annuities Not Recommended as Investment for Physicians.”]
Question. I met with a financial advisor who thinks I should buy an annuity instead of funding my retirement accounts with mutual funds. What do I need to know about annuities before making this decision?
A. As a general rule, annuities are products that are made to be sold, not bought, and it should not be surprising that someone who is compensated for selling them would recommend that you buy them. It is OK to use a financial advisor, but choose a fee-only advisor, who is paid directly by you for advice. Taking advice from a commissioned salesperson is like going to a doctor who charges no fees but gets kickbacks from the lab and the pharmacy based on the number of tests ordered. That arrangement is illegal in medicine (for good reason) but legal in financial services.
An annuity, like whole life insurance, is another method of mixing insurance and investing. Instead of investing the money, either on your own or with others via a mutual fund, you purchase a contract with an insurance company. The insurance company usually provides guarantees of some type, and there are usually costly fees and surrender charges. Perhaps the best example of an annuity (and certainly the most useful) is the single premium immediate annuity (SPIA), where you give a lump sum to an insurance company and, based on your age, health, and current interest rates, the insurance company then provides you a monthly income for the rest of your life, no matter how long you live. You cannot get your money back, so when you die, even if it is the next week, the insurance company keeps the money. Typical rates range from 5 to 8 percent, so if you used $100,000 to purchase an annuity, you could get a guaranteed monthly payment of $417 to $667 every month for the rest of your life. Essentially, you have used a lump sum to purchase a pension. SPIAs can also have an inflation adjustment.
Annuities have other benefits. In some states, such as California, Florida, Indiana, Louisiana, New Mexico, and Texas, annuities offer substantial asset-protection benefits from creditors. Money in an annuity, whether in your name or that of a child, does not have to be listed on the Free Application for Federal Student Aid (FAFSA), although a physician’s family will rarely qualify for any need-based aid anyway.
Annuities have serious flaws that should prevent most physician investors from using them. Aside from a SPIA purchased around age 70 to put a floor under your retirement income, the first is the tax treatment.
As a general rule, annuities are products that are made to be sold, not bought.
The tax treatment (and usually the asset-protection features) of retirement accounts, such as Roth IRAs and 401(k)s, is far superior to that of an annuity. An annuity, like a Roth IRA, is purchased with money that has already been taxed and grows in a tax-protected manner. However, unlike a Roth IRA, which provides tax-free withdrawals, when you withdraw money from an annuity, you have to pay tax on the earnings. Unlike in a regular taxable investing account where you benefit from a lower qualified dividend and capital gains tax rate, annuity earnings are taxed at a higher regular marginal tax rate. To make matters worse, the law mandates that when withdrawing money, the earnings come out first. The only exception is if you “annuitize” the policy, where the company guarantees payments for life. In that situation, your principal is prorated to your life expectancy, and each month’s payment is then part earnings (taxable at your marginal rate) and part principal (tax-free since you already paid tax on it prior to contribution). Of course, this does not matter when the annuity is purchased with pre-tax money, such as with a 401(k), since none of that money has yet been taxed and would be taxed at your full marginal tax rate anyway. After age 70, the SPIA payments are considered the Required Minimum Distribution for that portion of the 401(k) used to purchase the annuity anyway. However, when compared with a taxable account, paying at your marginal tax rate instead of the lower long-term capital gains tax rate can easily erase the benefit of even decades of tax-protected growth. Also, just like with a retirement account, there is a 10 percent IRS penalty associated with withdrawing money prior to age 59½.
A bigger issue with annuities is that insurance companies and their agents love to add overpriced bells and whistles to these contracts. The contracts are written by lawyers and actuaries to be favorable to the insurance company, and complexity certainly does not favor the buyer. To make matters worse, the surrender fees associated with these contracts ensure that they are a bit like herpes—once you have it, you will never get rid of it. However, these bells and whistles provide multiple angles the annuity salesperson can use to interest you in the purchase, especially if you make the mistake of assuming the agent is providing unbiased financial advice. Unless you are an actuary with access to the actuarial data the insurance company has, you have no way of knowing if you are being offered a good deal or not. However, as a general rule, you can safely assume that none of the bells and whistles are being offered to you at a fair price. One of the most common added to annuity contracts these days is to index the annuity earnings to a stock index. This way, the agent can promise that you can “participate in the upside of the stock market without any risk of loss due to market risk.” While it is true you can “participate” and that you won’t “lose money” (unless you count the surrender fees), the fact is that, due to the numerous limitations spelled out in the lengthy contract, you are likely to only end up with a small fraction of the earnings of an index fund invested in the same stock index over the long run.
Annuities have inferior tax treatment when compared to standard retirement accounts. They also have inferior long-term returns when compared to low-cost index funds. While they can provide useful asset protection and some tax protection for particularly tax-inefficient investments, the only type of annuity most physicians should ever consider is a SPIA purchased around age 70 to combine with Social Security to guarantee a portion of retirement spending. Maximizing contributions to your 401(k) and backdoor Roth IRA (discussed in the Oct. 2014 column) and investing those contributions into a reasonable mix of diversified, low-cost index funds, while perhaps boring, is far more likely to lead to financial success.
Do you have an annuity? What kind? Are you glad you bought it? What was the feature that interested you the most in it? Comment below!
I have a low-cost deferred variable annuity from Vanguard, ER 0.53%. Still a hefty ER compared to the vanilla index mutual funds in my taxable account, and still unfavorably taxed upon withdrawal. But, my physician’s group doesn’t offer a 401k, so I’m faced with a huge taxable fund. I choose to put some of my income in the annuity for asset protection purposes. In that regard, the extra cost of the annuity is the price of insurance.
Not all financial advisors are adept at advising on variable annuities as far as when to annuitize . Can you recommend a financial advisor to help aid in decision making on VA with IRAs where Rmds are needed until annuitization, GMIB and death benefits exist too? Complicated products which I would like some guidance to make the best of this situation.
Thanks
Tough niche. Agents like to sell them but since most advisors recommend against them, it’s hard to find someone knowledgeable to help you sort out what to do once you buy them. Yet another reason not to buy them I suppose. At any rate, no, despite 10 years doing this I still haven’t met someone I would fully trust to send you to to do that analysis. You might try Stan the Annuity Man though. He certainly knows annuities well. Tell him I sent you and let me know how it goes.
If that’s what you want to do then id take my least tax efficient investment and put it in there such as REITS.
Absolutely- high expected return and low tax efficiency is what to put in there. REITs are a great option. Keep in mind that it may be less expensive to use a Jefferson National VA rather than a Vanguard one due to the flat-fee structure. 0.53% is a lot of money if you’ve got 6 or 7 figures in there.
Could you elaborate a little bit more on SPIA? What they are and why and why not to use them?
https://www.whitecoatinvestor.com/spia-the-good-annuity/
Thanks, it does get hard for me to digest that if I die money from it doesnt go to my heirs (plus no COLA without increase cost). Hopefully I wont need guaranteed income when I retire and hopefully should be able to live on my portfolio. Anyways long ways to retirement or 70. Should re-evaluate later.
Absolutely. Those who have plenty of assets don’t benefit as much from them as someone that’s just on or just below the line of what they really need.
definitely something you evaluate at that time. I also agree that if you have tons of money then it isnt that useful. I am considering the purchase of a non inflation protected SPIA at age 80 for basic needs. As you noted the inflation adjusted ones just decrease initial payout and most are capped on the inflation adjustment as well. If my health isnt great at age 80 then i wont do it. Ideal situation for me at that time even if i dont need it would be awesome health, current high interest rate environment, and a desire to simplify part of my investment plan. Given that im planning on deferring SS to age 70, that i plan to work and save for many years, its not that likely that i will need a SPIA. The good thing about a SPIA is that its fairly transparent as far as insurance products go.
Please what are your thoughts about rolling over a 401k from my previous job to a fixed index annuity through Nationwide as recommended by my accountant?
Does your accountant have a relationship with the annuity salesman or something? I would be VERY hesitant to buy any annuity that wasn’t a very straightforward and competitive SPIA for someone in their late 60s.
I am holding a Kaiser Permanete annuity worth 1,600 with an ER of 0.43%. I was perfectly happy to let it sit for all eternity, Just got a letter saying that I can no longer hold the annuity becasue I am no longer an employee and the balance is less than 5,000. If I do not take action the balance will be rolled into a default IRA account.
What is my best option here?
Would this count toward my 2019 roth contribution limit? Pro-rata rules? Can I put the money into a 401k?
I’ve held on to this annuity for 5 years because I was never sure what to do with it. Now I have to decide!
Why not roll it into an IRA and convert it to a Roth IRA if that is allowed? That’s what I’d do.
No, rollovers don’t count toward contribution limits. As long as you convert it or roll it into a 401(k) this year, no pro-rata issue.
I’m not a physician (wife is, however, and I love your podcast), but rather am CEO of a quasi-public agency. I have a variable annuity through Met Life recommended to me by a friend who is also a financial adviser and sells Met Life products. When I was hired to run the agency I negotiated an annual retirement contribution of 10% of my $155k salary. 3% of that is the retirement match available to all employees, however our retirement plan would not allow me to receive a different retirement match than the rest of my employees. My friend advised that the remaining 7% I was owed – $10,850 – should be placed in a restricted account. This, we both reasoned, would demonstrate to my governing board that I was respecting the spirit of the employment agreement. Additionally, the $10,850 would have to be a separate check and I would need to show the state auditors that I had placed it into some restricted retirement account. My friend recommended the variable annuity and I’ve had the account for a year now.
This year I discovered your podcast and have since done a backdoor Roth for both my wife and me. We max out our 457 (me) and 401k (her) and have one remaining IRA contribution to make this year, which I will subsequently convert to a Roth. This year I will receive another check for $10,850 and am wondering if it makes sense to put all or any of it into the variable annuity again. I certainly want to place $6000 of it into my IRA (recently converted my pre-existing IRA balance to a Roth and opened a new IRA for my wife and converted it to a Roth, therefore I can still contribute to my IRA
then convert to Roth).
Should I place the remaining $4850 into the variable annuity? Should I keep the variable annuity at all? If it helps, we are 44 (me) and 40 (her) and our retirement account balances are over $454k. Therefore the variable annuity is not a big part of our retirement portfolio, but since listening to you I’m skeptical about using insurance products for retirement savings. Because of you I’m in the process of canceling my whole life insurance policy!
Thanks for your help.
What are the details of the VA?
Of course, never forget that even a taxable account can be invested very tax efficiently.
Thanks for the information regarding a 1035 exchange. I will keep that in mind.
The current account balance and death benefit is $11,449.56. Surrender penalty $789.50. Top 5 holdings are MFS Value Portfolio, PIMCO Total Return Portfolio, T. Rowe Price Large Cap Growth Portfolio, American Funds Growth Portfolio, and BlackRock High Yield Portfolio. Our plan was to allocate this account more aggressively since my main retirement accounts are all passively allocated via the lifecycle funds (TIAA Cref & John Hancock for me, Vanguard and Fidelity for my wife).
The annuity prospectus cites a 1.05% annual mortality and expense charge, .25% annual administrative charge, and a $30 annual account fee. That is on top of the investment portfolio expenses which are paid out of the assets of each investment portfolio.
That is all I could find from my scan of the prospectus. I do have the Principal Protection Rider which I recall is there to insure I never lose more than I put in the account.
Again, thanks for your help and feedback.
Are you allowed to take it as cash? If not, I guess you get the VA. It could certainly be worse.
No, taking it as cash would offend the spirit of the retirement contribution component of my compensation package. I will likely receive a raise for 2020, so that 10% retirement contribution will only grow. I think my strategy for this year is to use $6000 as the second IRA contribution for 2019, which I will subsequently convert to my Roth IRA. The remaining $4850 can go in the VA for now.
What did you think of the fee structure I posted above? Par for the course?
I would certainly appreciate any additional thoughts on how to structure my compensation package. Right now I have a base salary of $155,000, a 10% retirement contribution, a car allowance, phone allowance, and full benefits. I requested the retirement match as a way to receive additional compensation without a base salary that might be viewed as excessive by public agency standards. As I renegotiate my contract (mostly to include a raise), its a perfect time to be more strategic with how I set this up and continue to max out all available retirement account options or simply maximize the opportunity more.
Again, thanks so much for taking the time to engage me.
A little on the high side I would say. I’d try to use something cheaper if I could.
Wow, interesting situation. If a variable annuity (VA) is the only kind of “restricted account” that you can think of, I’d at least put it into a low-cost no-load VA. Fidelity has one, Vanguard had one but I think they’re doing away with it, and there are other providers out there. I’m willing to bet the Met Life VA is probably a loaded VA with a big surrender charge and an expense ratio of more than 1-2%, depending on your sub-account choices. They key data are the mortality and expense charges on the annuity, plus the individual expense ratios of the sub accounts, and the surrender charges. If you find a good one, you can do a 1035 exchange of your existing VA to the new one.
This is baloney.
No one in the financial services industry works for free. A fee-only financial services advisor has as many conflicts of interest as any life insurance or annuity salesperson – it’s baked into the market and there’s no getting around it. These fee-only advisors want you to not only pay your fees to them, but to buy their newsletters and books, subscribe to their services, etc. And believe me they have their own referral relationships.
And they’re not conflicted?
I also don’t see any of them on welfare – stockbrokers either…
The idea that annuities are designed to make the financial advisor / salesperson rich is a cheap game of envy.
If annuities are a bad deal, then why are so very many top Fortune 500 companies funding their employee retirement benefits with them?
The key is to get knowledgeable advise from professionals you trust.
I disagree. I find the conflicts of interest for someone paid on commissions to be far higher than someone paid fees for advice or service. That’s pretty evident to everyone but those who sell these products. As Upton Sinclair said,
No one around here is envying a person with a job that requires them to sell bad products that hurt their clients financially, no matter how much they make doing so. You’ll have to ask the HR folks at those Fortune 500 companies what they were thinking.
Spouse had multiple variable annuities(3 with differing amounts in the accounts). What should be the strategy in withdrawing funds when reaching age of RMD and for annuitizing?
Thanks
Depends on the rest of the financial plan. That can’t be looked at in isolation. Annuitizing could be reasonable but they could also be left to charity, left to heirs, or withdrawn from periodically or in lump sums. VAs do not have RMDs UNLESS you bought them in an IRA which is often a mistake.
How can i get out of a variable annuity?
You can surrender it, paying any fees and taxes due.
The “financial advisor” had advised me to rollover my 403b money to a VA when I changed jobs. The pitch was it will guarantee income after retirement. After hearing your podcast I realized the dumbest mistake in my life. The contractor says that I can surrender after 7 urs with 0% surrender charge. That will be in 19 months . I want to get out of the VA and perhaps rollover to my current retirement account. Do I wait after 19 months? I can withdraw 10% free of any surrender charge. Where do you recommend I transfer the asset to? I appreciate the help that you do to educate doctors on what to do with their hard earned money.
What value do you get now and what do you get in 7 months? Will you make up the difference in another investment?
What you invest in with the money when you’re done with the annuity depends on your investment goals and written investment plan:
https://www.whitecoatinvestor.com/balancing-financial-goals/
https://www.whitecoatinvestor.com/investing/you-need-an-investing-plan/
It was suggested by my advisor that I consider annuitizing my TIAA Traditional (joint life; 15 year guarantee). If I annuitized 400K, the guaranteed fixed monthly income would be $2524/mo at our age (both my wife and I are 71). To evaluate that, I created two (worst and best case) scenarios to examine the alternative of systematic withdrawals from an invested lump sum: (1) we both die within the 15 year guarantee period, and (2) we both live beyond the 15 years. For the first scenario, I found that to pay myself $2524/mo and break even at 15 years, the lump sum would only need to be invested in something that earns 1.73% . For the second scenario, I determined what lump sum TIAA would require for an 86 year old couple to purchase a joint life fixed annuity with no guarantee period ($253K). I then determined what ROI I would need from my 400K lump sum investment to leave 253K at age 86. That turns out to be much higher, but still only 6.06%.
So, if we annuitize, the ROI would be somewhere between 1.73% and 6.06%, depending on when we die. Since you can currently earn 6.0% with TIAA if the money is locked for 10 years with ability to withdraw 10%/year, that seems like a far better option for a safe fixed stream of money.