Annuity Pitfalls

Annuities provide a reliable retirement income, but it comes at a cost.
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For investors, the 21st century hasn't been an especially happy time. The dot-com collapse let a lot of air out of the markets back around the turn of the century, and the housing collapse in 2008 didn't help either. With so much uncertainty in the financial sector and the world at large, a lot of investors have been looking for some certainty in their portfolios. That's led to a revival of interest in annuities, a dowdy and unglamorous investment that holds the alluring prospect of a guaranteed retirement income. However, those guarantees are accompanied by a variety of potential pitfalls.

Annuity Basics

Annuities can be summed up pretty briefly. You give a bunch of your money to an insurance company, and in return the company gives you a retirement income. Of course, that's just the broad strokes. They're complex contracts, with lots of variables. You can pay into the plan with a lump sum, or you can make payments ahead of time for decades. You can take the payments for a set time, or for the rest of your life. You can accept the insurance company's guaranteed return, or use the annuity to hold market-driven investments instead. Each type of annuity has its own drawbacks.

High Costs

One of the major pitfalls of annuities is that their costs are higher than other retirement vehicles. That's because they have an insurance component as well as an investment component, and both must be funded. The contracts also pay healthy commissions to the brokers who sell them. These costs seriously erode the returns in your annuity, when compared to a corresponding mutual fund. If you need to pull your funds out of an annuity during its early years, the charges can be 20 percent or more. They'll usually dwindle to zero over seven to 10 years, but it's a serious limit on your liquidity.

Diminished Returns

In the course of your lifetime, you'll only have so many dollars to invest. The better your returns are, the more money you'll have for retirement. That can be problematic when you're invested in annuities. Fixed-rate annuities rely on the insurer's investment pool, which is required by law to be rather conservative. Variable annuities, the kind that invest in conventional funds and equities, can lose money and reduce your safety net. Even when they perform well, their high management costs make them unappealing.

Death and Taxes

Many of the details in an annuity contract are related to their insurance function. Most annuity contracts pay a death benefit, like life insurance, if you die before collecting on your investment. However, most only pay out the amount of your payments -- the company keeps the profits. Once you've started drawing an income, many annuity contracts will simply terminate if you die. Not one cent goes to your estate. If you withdraw money from your annuity, there can also be tax repercussions. It's recorded as regular income, not capital gains, and taxed at a higher level. There can also be a further 10 percent penalty, if you're 59 or younger.

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