[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!