It's not uncommon for IFA's wealth advisors to be asked by investors whether they need to buy an annuity contract. Pitched by insurance companies and broker-dealer networks, an annuity is a financial product that provides a regular stream of income for a specified period, usually for the life of the annuitant. 

At first glance, such a deal might sound attractive. But we like to caution anyone considering signing one of these insurance contracts to understand all of the product's features.

One of the main criticisms of annuities is that they often come with high fees and charges, which can eat into the returns on your investment. Also, since an annuity is essentially a contract between the investor and an insurance company, terms can be inflexible — meaning you might not be able to access your money easily (or, without incurring extra fees) if you need it.

Below is a summary of five key issues that IFA's Investment Committee recommends potential buyers be aware of before committing to an annuity contract.

1.) High fees: One of the most significant concerns with annuities is the fees associated with them. Annuities often have several layers of fees, including mortality and expense risk charges, administrative fees, underlying fund expenses, and optional rider fees.¹ These fees can significantly reduce the overall returns of the annuity, which can impact the income stream during retirement.

2.) Surrender charges: Annuities often have surrender charges, which are fees charged if you decide to withdraw your money or cancel the annuity contract before a certain period.² These charges can be quite substantial and can last for several years, making it essential to understand the surrender schedule before investing in an annuity.

3.) Tax implications: Annuities grow tax-deferred, meaning you don't pay taxes on the gains until you start receiving income from the annuity.³ However, once you begin withdrawing money, the gains are taxed as ordinary income, which can be at a higher rate than long-term capital gains. Additionally, if you withdraw money before age 59 1/2, you may be subject to a 10% early withdrawal penalty.⁴

4.) Limited liquidity: Annuities are designed to provide a long-term income stream and are not suitable for short-term financial needs. Withdrawing money early can result in surrender charges and tax penalties, as mentioned earlier. This limited liquidity can be an issue for investors who need access to their funds for emergencies or other financial needs. ⁵

5.) Financial strength of the insurance company: Again, an annuity is a contract between you and an insurance company, and the guarantees provided by the annuity are only as strong as the financial strength of the insurance company.⁶ As a result, it's essential to research the financial strength and credit ratings of the insurance company offering the annuity before investing.

Footnotes:

1. FINRA website, n.d., "Investment Products: Annuities for Investors."

2. FINRA website, n.d., "Annuities: Essentials."

3. SEC, n.d., "Variable Annuities: What You Should Know."

4. IRS, April 24, 2023, "Topic No. 410 Pensions and Annuities."

5. IRS, Sept. 19, 2022, "Retirement Topics - Exceptions to Tax on Early Distributions."

6. AM Best, n.d., "Understanding Best's Credit Ratings."

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