As a young professional who will make a lot of money over the course of your career, you may be approached by a financial advisor. Although some advisors can be great assets, others were trained as salesmen and may not have your best interest at heart. They may overcharge for advice or worse, convince you to purchase expensive investment products you may not need. One of the products you should be weary of purchasing is an annuity.
What is an annuity?
An annuity is a type of investment product you can purchase from an agent at a brokerage or life insurance company. You pay a set amount of money to the company (via a lump sum or in monthly payments), the company invests that money on your behalf. After a certain time period, the company will then return the money you gave them back to you in smaller fixed monthly payments (usually for the rest of your life) with interest. In other words, you give the company your money now to invest and the company returns your money back to you later (in small payments) with a certain amount of interest. It some ways, it is similar to a bond (with many more fees attached, as we will discuss below).
When it comes to annuities, there are different types. The main types are immediate annuities and deferred annuities. With an immediate annuity, you pay a lump sum for the annuity and the company starts paying you in monthly installments immediately. There is no waiting period between the time you purchase the annuity and the time you receive your first monthly payout. With deferred annuities, there is a waiting period. You may pay for the annuity with a lump sum or with fixed payments, then you wait a number of months or years before you get your first payment. Along with the timing of when you get your first payout, there are also variations in the amount of your payout. Some annuities have fixed payouts in which you receive the same amount of money each month. Other annuities have variable payouts (in which your monthly payment changes based on how well or how poorly your money is being invested). Lastly, some annuities have payouts that follow a certain index (like the S&P 500).
Why do some financial advisors recommend them?
It may provide a guaranteed income. By purchasing an annuity you get a set amount of money no matter how long you live. If you don’t know much about investing and want to virtually ensure that you will have a certain amount of money each month in retirement you can buy this product. Financial advisors may also state that this product is better than investing in taxable accounts because the profits are tax deferred until you start getting withdrawals/payouts. Annuities are sometimes purchased by retired individuals who fear they may outlive their retirement savings and want to guarantee themselves a monthly payout for the rest of their lives.
Why you should be weary of an annuity?
The agent and company takes a large portion of your investment returns
In order for the company to be able to guarantee you an income for the rest of your life they have to make sure you give them enough money to cover the cost of the payout they will give you while also netting themselves a profit. They need to be able to pay you and make money for themselves. Companies who sell annuities are businesses not charities. Ensuring a profit for themselves is how they stay in business. Unfortunately, this profit is at your expense. While a small cut is reasonable, many of the agents and companies who sell annuities take rather large cuts of your profit, often up to 10% of the total value of your payout.
The money you loan them is invested in inefficient ways which reduces your profit and payout
Along with the agent and company taking a rather large portion of your payout, the payout that you do receive is often not as a large as it should be. Why? Because the money you put into annuity is usually invested in inefficient mutual funds that have a track record of underperforming the market (getting lower investment returns than the average). Plus, many companies charge high expense fees on the profits you do make. In other words, you get lower investment profits and have to pay more even more money in fees for them.
Purchasing an annuity is inflexible and binding.
If you want to take money out of the annuity early (to get payouts sooner or increase the amount of your payout temporarily to pay for a large expense), it is extremely costly. You would have to pay a high percentage in taxes to take money out sooner. Plus, if you want to sell the policy or get rid of the policy at any point, the company will charge you an exorbitant fee (often 10% of the value) to “surrender it.” Lastly, once you start getting your fixed payments, you have to pay taxes on this income at your ordinary income tax rate which tends to be much higher than the capital gain tax rate you would have been charged had you simply invested your money in an taxable account yourself instead of purchasing/investing money in an annuity.
What is a better alternative to an annuity?
Prioritize retirement accounts like your work 403b and Roth IRA. Through employer-sponsored retirement accounts you can contribute money to invest for retirement in a way that lowers your taxes each year. You may also get extra “free” money to invest if your job offers a retirement “match” (extra money employers put in your retirement account free of charge as a bonus for choosing to invest). Along with those two perks, prioritizing retirement accounts lowers your taxable income which can decrease your student loan payments. Retirement accounts like a Roth IRA, even offer a wide variety of investment options and allow you to get tax-free growth on your profits. A Roth IRA also allows you to take out your contributions at any time instead of having to wait until you retire, providing more flexibility and serving as a backup emergency fund should unexpected expenses arise.
Invest money in index funds via taxable accounts (after maxing out retirement accounts). Instead of purchasing an annuity, you can simply open a brokerage account and invest the money in low-cost index funds. Doing so, will allow you to invest even more money, on top of what you already invested in your retirement accounts, to build your net worth sooner. With taxable accounts, you can withdraw the money at any time and your profits will be taxed at lower rate.
My point? Annuities may seem like good idea but many young professionals should be weary of them because they tend to be costly, expensive, and inflexible. The money in them is often invested in suboptimal ways and the agents and company who sell the policy take a large chunk of your money. Instead of opting for an annuity, invest money in low-cost index funds since they have low fees, good profits, and lots of diversification that decrease your risk of losing money. When investing in low-cost index mutual funds, you may first want to prioritize doing so through retirement accounts (due to the tax advantages) then opening up a brokerage account to invest the rest. Unless you are currently retired and fear you may outlive your savings, annuities may not be the best investment option.