Common Annuity Misconceptions

“All annuities work the same way.”

Annuity contracts can differ substantially. They may be classified according to whether income begins immediately or later, whether interest is fixed or index-linked, whether the contract value is exposed to investment-market performance, whether income is created through annuitization or an optional rider, and whether the contract is funded with qualified or nonqualified money. Immediate, deferred, fixed, indexed, variable, and registered index-linked annuities may have very different risks, guarantees, expenses, and withdrawal provisions. The word “annuity” identifies a category of insurance contract—not one standard product.

“An annuity guarantees that I cannot lose money.”

The answer depends on the type of annuity and the terms of the contract. Fixed-annuity guarantees generally apply according to the contract and are supported by the issuing insurer’s financial strength and claims-paying ability. However, variable annuity values can decline because of investment performance; registered index-linked annuities may expose the owner to part of an index decline; withdrawals, surrender charges, rider fees, and market-value adjustments may reduce a contract’s value; indexed annuities that are securities may experience losses under certain conditions; and an insurer’s guarantee is not the same as a federal government guarantee. Instead of asking, “Is this annuity guaranteed?” ask: “Exactly which amount or benefit is guaranteed, under what conditions, and by whom?”

“An indexed annuity earns the same return as the stock-market index.”

An indexed annuity does not normally give the owner direct ownership of the stocks contained in the index. The amount credited to the annuity may be lower than the index’s reported return because the calculation may exclude dividends, apply a participation rate, limit growth through a cap, subtract a spread or margin, or use a particular measurement or crediting method. For example, when an index rises by 10%, a contract with a 60% participation rate may credit only 6%, subject to the complete contract formula. Crediting limits may also change when the contract allows the insurer to revise them. Index-linked does not mean identical to the index.

““Guaranteed income” means I can always withdraw the full amount.”

Income benefits and cash values are not always the same. When an owner permanently annuitizes a contract, the amount used to create the income stream may no longer remain available as a lump-sum withdrawal. An optional lifetime-withdrawal rider may preserve greater access than annuitization, but it will have its own rules. Excess withdrawals may reduce or eliminate the future income guarantee. Some contracts display an income base or benefit base used to calculate future payments. That figure should not automatically be treated as the contract’s cash value, the amount available for surrender, the death benefit, or an amount available as one lump-sum withdrawal. The written contract determines what is accessible and what is used only to calculate income.

“Money placed in an annuity is locked away forever.”

Many annuities permit withdrawals, but access may be limited or costly during the surrender period. A contract may provide a stated annual withdrawal amount without an insurer surrender charge, required minimum distribution provisions for applicable qualified contracts, waivers for certain qualifying events, partial withdrawals, or full surrender. However, withdrawals may still trigger surrender charges, reduce future income guarantees, reduce death benefits, cause a market-value adjustment, create taxable income, or result in an additional federal tax when taken before age 59½, unless an exception applies. Surrender schedules often decline over time, and later purchase payments may sometimes begin new surrender periods. An annuity may provide access, but access is not always free or consequence-free.

“Tax-deferred means tax-free.”

Tax deferral generally postpones taxation; it does not automatically eliminate it. Earnings in a nonqualified annuity may grow without annual federal income taxation while they remain inside the contract. Taxable amounts are generally recognized when distributions occur. Depending on the contract and funding source, earnings may be taxed as ordinary income; part of an annuitized payment may represent a return of after-tax contributions; qualified annuity distributions may be taxable under retirement-account rules; and early taxable distributions may be subject to an additional 10% federal tax unless an exception applies. Federal and state tax treatment can vary, so significant distributions should be reviewed with a qualified tax professional. Tax-deferred means “taxed later,” not necessarily “never taxed.”

“Placing an annuity inside an IRA creates double tax deferral.”

An IRA, traditional 401(k), or similar retirement arrangement may already provide tax-deferred treatment. Placing an annuity inside that account does not create an additional layer of tax deferral. The annuity would need to be justified by other contract features, such as a particular income guarantee, insurance-company guarantees, death-benefit provisions, a withdrawal rider, or other benefits appropriate to the retirement plan. The purchaser should understand why an annuity is being recommended inside an account that already receives tax-deferred treatment.

“All annuities have extremely high fees.”

Annuity costs vary widely by contract type. Variable annuities may include explicit charges such as mortality and expense charges, administrative expenses, investment-option expenses, optional rider fees, and surrender charges. Some fixed, indexed, and registered index-linked annuities may have few or no separately stated annual fees. However, they may contain implicit economic costs, including lower credited rates, caps on positive returns, participation rates, spreads, restrictions on access, and reduced payments in exchange for survivor protection. A contract described as “no annual fee” is not necessarily free of economic trade-offs. Evaluate explicit charges, indirect limits on growth, surrender terms, rider costs, and benefits received in exchange for those costs.

“Beneficiaries will always lose the remaining money.”

What happens at death depends on the contract and the income option selected. Some annuities provide a stated death benefit during the accumulation phase, continued payments for the remainder of a guaranteed period, joint-and-survivor income, a return-of-premium provision, or another beneficiary option. However, a life-only income option may stop at the annuitant’s death, even when the total payments received are less than the original amount applied to the income stream. Adding beneficiary protection may reduce the amount of periodic income because the insurer may be obligated to make payments for a longer period. Variable annuity death benefits may also involve additional costs or contract conditions. Do not assume either that beneficiaries receive everything or that they receive nothing. Review the selected death and income provisions.

“Replacing an older annuity with a new one is automatically an upgrade.”

A new annuity may offer different benefits, but an exchange can also create new costs and limitations. Replacing an existing annuity may trigger a surrender charge on the old contract, begin a new surrender period, cause the owner to lose existing income or death benefits, replace favorable guarantees that are no longer available, create new rider charges, change credited rates, withdrawal rules, and beneficiary provisions, or generate compensation for the person recommending the replacement. A qualifying Section 1035 exchange may permit certain annuity-to-annuity exchanges without immediately recognizing taxable gain, but it does not remove surrender charges or guarantee that the replacement is beneficial. Before exchanging, compare the old and new contracts side by side.

“An annuity is always the best retirement solution.”

An annuity may help address specific retirement concerns, but it should be evaluated as part of the household’s broader financial picture. Important considerations include existing Social Security or pension income, essential monthly expenses, emergency savings, healthcare needs, need for access to cash, inflation risk, investment risk tolerance, retirement timeline, beneficiary and legacy priorities, and other available retirement assets. An annuity generally should not absorb money needed for short-term expenses or emergencies. Regulators describe annuities as long-term products and caution that early withdrawals may result in taxes and surrender charges.

“Annuities are either good or bad.”

An annuity is a financial contract with benefits, limitations, costs, and risks. Whether a particular annuity is appropriate depends on the purchaser’s objective, the specific contract, the amount allocated, the income or protection being sought, the alternatives available, and the owner’s ability to understand and accept the trade-offs. A contract that is useful for one retiree may be unsuitable for another. The correct question is not, “Are annuities good or bad?” A more useful question is, “Does this particular contract solve a clearly identified need, and are its costs, risks, restrictions, and alternatives fully understood?”