5 Reasons to Avoid Annuities

Safe payouts can come with some strings attached.

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Annuities have become more popular as investors continue to look for guaranteed returns. Salesmen will try to convince people that they need variable annuities, with a pitch that sounds like "if the market goes up, you will participate; if it goes down, you won't lose any money." Here are a few things to know about annuities that many salesmen probably won't explain to you.

1. You might pay a lot more in taxes. One selling point for variable annuities is that the growth in their value is tax-deferred. But when you withdraw money from an annuity, the gains are taxed as ordinary income, which could run as high as 35 percent at the federal level. However, when you own a mutual fund, as long as you hold it for a year and it rises in value, you will pay a maximum long-term capital gains tax of 15 percent when you sell. So when you buy an annuity, you could end up paying more than twice as much in taxes on the exact same amount of gains.

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2. The income guarantees may not be as good as you think. It's understandable that investors would be lured by a 3 percent guaranteed return that some variable annuities seem to offer, especially in an uncertain or down market. Another gimmick is teaser rates, which may be an 8 percent or 9 percent return for the first year. After that, the return rate goes to the "market rate," which is set by the insurance company and shouldn't go below the guaranteed rate of 3 percent. So for a 10-year annuity, you'd get 9 percent in the first year and 3 percent annually for the next nine years. You might as well stash your cash in a savings account. Insurance companies don't pay out more money than they receive in fees, so these billion-dollar firms wouldn't sell a product unless they could make money from them.

3. Fees and expenses are often two to three times higher than mutual funds. Annuities are insurance products sold by salesman looking for commissions, which typically range from 7 percent to 10 percent. In addition to the sales commission, insurance companies slap on another layer of annual fees—usually 1.5 percent to 3.5 percent—so you're paying more for the same type of investments that can be bought outside of the annuity. Given that annuities are long-term investments, the fees add up over time and lower your returns.

4. There are plenty of restrictions and provisions. Insurance salesmen will show you an attractive brochure highlighting all the benefits of an annuity. However, inside the other document they give you, a thick prospectus, are a lot of restrictions and provisions that will dictate what will happen with your money and what you, and the insurance company, can do or not do over the years. The devil is in the details. Most of the text is boilerplate, but you have to read each page of that prospectus before you buy an annuity. For example, similar to most retirement accounts, there's an early withdrawal penalty of 10 percent if you take money out before age 59 1/2. Also look for explanations about surrender periods (more on that below) and all fees and expenses.

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5. If you withdraw money from an annuity too soon, you'll pay a surrender penalty. Many annuities carry at least a seven-year surrender period. That means if you change your mind within seven years, you'll pay as much as a 15 percent fee to get your money back. However, surrender penalties should not be a reason to hold onto an annuity. A lot can change in seven years, including your attitudes, market conditions, and the health of the insurance company. More importantly, if your goals, aspirations, and tolerance for risk change during the first seven years and don't match what you own in the annuity, you're better off getting out and paying the penalty. It's sort of like getting the flu shot every year. Sure, that shot hurts. But the temporary pain is better than suffering from the flu for a week. Rather than sticking with an annuity that can drag you down, sell it and pay the penalty. Then search for better mutual funds with lower costs that will suit your investment goals.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April, 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store system.