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How do annuities work?

Updated: May 25, 2022

Annuity and pension guarantees can work against you.


  • What sounds too good to be true usually is.

  • Annuities come in many different forms and are very complex.

  • You can expect excessive fees and limited investment returns.

  • Distribution options risk you leaving hard-earned money on the table.

  • There are benefits to using an IRA vs. an annuity.


Guaranteed 6% returns.

Guaranteed income for life.

No exposure to market volatility.

Where do I sign up, right? Especially in this market.

Well, let’s hold that pen for just a minute to take a closer look at what we’re really getting. Generous returns with no risk of loss that will provide a steady income stream for the rest of your life may sound great, but there’s a BIG catch.

See, annuities and pensions are contracts with insurance companies providing the guarantees. And the insurance companies are like casinos – they’re only in the game because they know that they will win.

These guarantees come at a significant cost to you. You pay for them with excessive fees while the actual (better) market returns go to the insurance company, and you risk losing what remains in the contract when you pass away.

To show you how an annuity looks and works, let’s walk you through a real annuity contract.

Confusing - Lost in the details

One of the biggest issues with annuities is their complexity. Look at the balances circled in red in this contract statement and explain what they mean.

Most people wouldn’t be able to explain the numbers the day after purchasing the contract, let alone five, 10, or 15 years later. But how do you make sense of these numbers and know that they are working for you?

When something is clear, you understand it. When you understand something, you are confident in it. This contract statement is not something that most people would look at and feel confident that they are prepared for retirement.

Expenses - Oh, the fees!

This example was a Variable Annuity contract that lets you invest your money alongside the 6% guaranteed return – if your investments do better, then you get the greater value. Sounds good, right?

Let’s look at the annual fees this client would have to overcome for his investments to outperform:

  • 2% admin fee

  • 0.95% on guaranteed income base

  • 0.80% on guaranteed death benefit base

  • 1.65% for each separate account (the investments – 2 of them)

In this case, that’s 7.05% per year, which means his investments would need to return more than 13.05% per year (6% guarantee + 7.05% fees), in order to outperform the contract’s guarantee. For context, the S&P has an annual rate of return of ~10% over the last 50 years.

In addition to charging these fees, the insurance company limits how much of the market upside you receive by placing a cap on investment returns. If the contract’s cap is 10% and the market is up 15%, then you miss out on 50% greater returns simply because the insurance company said so.

So, when there’s essentially no way to outperform the contract, you will likely feel forced to keep the annuity.

Risky - Income received vs. value of the contract

This is a big one.

Most people would assume that if one spouse is receiving an annuity benefit and something happened to that spouse, then the full income benefit would automatically go to the surviving spouse and/or children.

Unfortunately, that is not how this works. At the time of analyzing this contract, the income benefit value was $707,102. According to the most recent calculations, these are the primary options for the distributions of the income benefit.

Single Life Annuity

The contract owner is eligible to receive $3,763 per month or $45,156 per year, before taxes, if he starts collecting payments now. That sounds good on the surface, but here’s the problem – this income benefit is only guaranteed against his life. When he passes away, the income benefit goes away, and the insurance company keeps the balance of the contract.

He is 76 years old, so he needs to live past age 91 to collect the full contract value of $707,102. If he passed away prior to age 91, the remaining value of the contract goes to the insurance company.

Joint Life Annuity

If the contract owner wants the insurance company to pay the benefit over his and his spouse’s lifetimes, then the insurance company will reduce the annual benefit by 25% - down to $33,612 per year. It’s important to note that this reduction is effective at the time of starting the income benefit, not after the original owner passes away.

Based on the reduced joint benefit, he or his spouse needs to live to age 97 and 94, respectively, to collect the full value of $707,102. If they do not live to their respective ages, the remaining value of the contract goes to the insurance company.

With both options, the timelines to breakeven are far from favorable and you risk leaving a massive amount of money on the table.

Considerations for walking away

Getting out of the contract is an option. Clearly, the income benefit is not favorable to this client, but does walking away from the annuity make sense?

In this case, the surrender value – what the contract owner could take with him – was $525,480. Compared to the contract value of $707,102, he would be leaving $181,622 on the table.

But he’s not really leaving that money on the table. We identified the risk that the income benefit can be much less than the contract value based on his current age and reduced benefit to cover his spouse’s lifetime.

So, you can make the argument that the risk of leaving money on the table is greater in the annuity contract.

He can walk away from the contract and roll the balance into an IRA. When considering this option, think about these questions:

1) What are the tax consequences?

Because he would be transferring his balance from an Annuity IRA to a Traditional/Rollover IRA, there would be no tax consequences on walking away from the contract.

2) How long will it take to grow to the $707,102?

You need an average annual return of 3% to get from $525,000 to $707,000 in 10 years. You would need an average annual return of 6.1% to get there in five years. Both are very reasonable expectations.

3) Balances aside, are there any other benefits to being in an IRA versus in the annuity?

There are several benefits of being in an IRA instead of the annuity contract:

  • Fees go from 7.05% to 1.5%, a difference of 5.55% or $29,137 per year

  • Participation in the full market returns (no caps)

  • Full control of timing and amount of distributions to manage taxes and Medicare premiums (vs. fixed annual distributions)

  • If something happened to him, then every penny of the IRA goes to his beneficiary(s)

  • If something happened to both spouses, then every penny goes to their beneficiary(s)

So, would you still buy an annuity?

While annuities seem like great solutions on the surface, you’ll find plenty of trade-offs once you look behind the curtain.

If you’re considering an annuity, then keep in mind that the perceived benefits can be replicated in a traditional investment strategy, with the added benefits of control and flexibility.

If you already own an annuity, then going through an exercise like this with a fiduciary will help you understand what you own and how much protection you can expect from your contract.

Know what you own. Know why you own it.

If you don’t, then you can’t have confidence in your plans to navigate retirement.

Frank Iozzo, CPWA®

President, Private Wealth Advisor

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