5 BIGGEST Annuity Mistakes and How to Avoid Them
Annuities continue to be a popular choice for retirement planners given their main objective is a guaranteed stream of income. In simplest terms, an annuity is a contract between a person and a financial institution (usually an insurance provider). It exchanges present contributions for future income. It’s a common retirement planning tool for those looking to lower the risk of outliving their savings. Though the fundamentals are pretty easy, the contracts themselves can be quite complex. Choosing the wrong annuity or insurance provider can end up losing you money rather than setting you up with income for life. Let’s take a look at some of the most common (and biggest!) mistakes investors make with annuities and how to avoid them.
1. Investing Too Much Money
There are no limits to how much you can invest into an annuity. But, that doesn’t necessarily mean that you should invest an enormous sum. The amount you invest should depend on your immediate and potential financial needs, your long-term goals, and your savings. It’s also a good idea to take into consideration what you already have invested elsewhere and what returns are likely.
With an annuity, part of your payout is a return of your principal. To create extra income from an annuity, you would choose a product like a variable annuity, which relies heavily on how the market does. Once you pay into a variable annuity, you lose control of how the money is invested, meaning, if you invest too much, you could potentially lose a lot.
Annuities that allow you to withdraw money after investing it, like a deferred annuity, pose a large risk of losing your guarantee of future income as well. Think of it this way: you pay a large amount into an annuity, something comes up and you need cash now, so then you take money out earlier than you intended. OK, you have the cash you need, but now your long-term plan is a little light.
How to Avoid it:
First, choose a low-fee financial advisor to work with; someone who won’t push you to invest more than you should. Second, make sure that you understand how much you have now and plan to have later on. After taking a little guidance from an advisor, go into your annuity shopping knowing that around 20-25% of your assets is a reasonable, less risky amount to invest.
2. Buying Without Understanding
The foundation of an annuity is simple enough. Buy the contract now, get income later. But unfortunately, that’s usually where the simplicity ends. Contracts are written up differently depending on what financial institution is doing the selling. Many end up being awfully complex and even downright hard for the layman to understand.
How to Avoid it:
If you don’t fully understand it, then don’t buy it! Work with a low-fee financial advisor to pick an annuity that works best for your retirement goals. Every annuity will come equipped with disclosures that explain the terms of your agreement. Read and work to understand them before you buy.
3. Not Paying Attention to Fees
Annuities usually come with fees and commissions. Working directly with an insurance provider can easily cause the buyer to overlook these fees that often stack up quickly.
How to Avoid it:
Understanding the fees each insurance provider charges will enable you to make educated comparisons while annuity shopping.
Several types of fees are common. These include:
- Mortality and expense fees: This can be around 1% per year, or equal to a percentage of your account’s total value. Mortality and expense fees compensate the insurer for “losses that it might suffer as a result of unexpected events, including the death of the annuity holder.“
- Administrative fees: These are filing charges that are usually a flat-rate and only occur once.
- Penalties: Withdrawals, before you hit the age of 59 1/2, are subject to a 10% early withdrawal penalty tax.
- Surrender charge: This is a fee that is imposed when an annuity’s principal amount is withdrawn before its surrender period has expired.
4. Failing to Name a Contingent Beneficiary
If the primary beneficiary of an annuity dies, and no contingent beneficiary is named, then the payout will go to the owner’s estate. That money then becomes subject to the probate process.
How to Avoid it:
Name a contingent beneficiary! This can be a person, organization, trust, or even a charity. It’s important to note that minor children and pets cannot be named because they do not possess the legal power to accept assets. However, if a minor child is named as a contingent beneficiary, in the event the primary beneficiary passes on before that child is of age, a legal guardian can be appointed to oversee the money until the child becomes an adult.
5. Assuming All Annuities are the Same
Though the basics are all the same, no two actual annuities are. Annuities are contracts. And, those contracts are written up by insurance providers. Each one written by a different company. See where we’re going with this? Even two annuities written by the same company can differ greatly.
How to Avoid it:
Always read the contract and its fine print. Shop around for different providers. Consult your financial advisor as needed. If you don’t understand something, ask about it.
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Originally published April 13, 2023
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