Annuity Investment Mistakes to Avoid

Making investment decisions has never been an exact science, nor is the process the same from one individual to the next. There are many variables that need to be factored, both from the standpoint of your individual situation and in the consideration of specific investments.
The objective is to match your needs, priorities, preferences and tolerance for risk with the appropriate investment alternative; not an easy task considering there are literally thousands of investment products from which to choose. Because it can be both expensive and troublesome if a mistake is made, it is important to exhaust all efforts in avoiding them in the first place. Here are some major mistakes people can make with any investment decision, but particularly with annuity investments:

Mistake #1: Not having clearly defined investment objectives

It’s one of the worst mistakes you can make with any investment. But, with an annuity, you may have to live with it longer unless you want to pay a hefty surrender fee. Before considering any investment, it is vitally important to know exactly what it is you want to accomplish, including a specific time horizon and an accumulation amount framed in the level of risk you are willing to tolerate. Only then will you be able to match your needs to a particular investment.

Mistake #2: Investing in something you don’t understand

It is said to be the key to Warren Buffet’s success. He never invests in anything he doesn’t fully understand, from top to bottom. Having read this report, you may have a better understanding of annuities than most people, but each annuity contract is slightly different. You’ve learned that annuities have many moving parts, and they tend to move differently from one contract to the next. You’ll know when you have a complete understanding of a product when you can explain it in terms an eighteen-year old can understand it.

Mistake #3: Investing with a clear strategy

In the right situation, an annuity can be an ideal investment, but any investment needs to be considered in the context of an overall investment strategy. Making investments on an ad hoc basis, or without consideration for other investment needs, such as liquidity needs, or tax implications, or diversification needs, or allocation requirements, can lead to disappointing results in the long term. An annuity should be considered as one component of a coordinated strategy that addresses all of your objectives.

Mistake #4: Failing to shop and compare

Most annuities are sold, not bought meaning investors are generally introduced to annuities by a sales person or financial planner who recommends the product. That would be OK if you are presented with a number of product choices and all of the features and benefits are clearly explained and compared. Often times, the product is the only one that they offer and it may not be the most competitive product on the market. Once you learn how annuity products work, you should be able to conduct your own comparison and evaluation. With the advent of the Internet and online annuity comparison sites, it’s as easy as screening products by different features, rates, fees and options. You can quickly narrow your choices from among hundreds of annuity products. Time invested: A few hours. The value to you: Priceless.

When you do meet with a financial professional, it is important to establish his or her qualifications and credibility as an objective provider of sound annuity advice. Be prepared to ask these 10 tough questions:

1. How many years of experience do you have?

2.What are you credentials?

3. What are the fees, caps, spreads, and surrender charges?

4.What happens at death?

5.Is there any risk of loss of principal?

6.What’s the maximum annual withdrawal?

7. Is there a confinement waiver for long term care needs?

8.Who’s going to service my account?

9. Is my account protected against inflation?

10.What financial institutions are standing behind these guarantees?

Mistake #5: Shopping rates instead of companies

When you begin your search for annuity products, you are likely to come across promotional ads blasting high yield offers and other tempting features. In an extremely competitive market, life insurers must be able to get your attention, so they will often times promote high initial rates, high participation rates (indexed annuities) or low surrender fees. It is important to remember that annuities are long term investments, and what happens in a product in the first year or two, may not make much of a difference over the long run. The more important consideration is whether a company will still be in a financial condition ten or twenty years out to be able to back its guarantees and meet its obligations.

Currently, there are about 30 life insurers that offer annuity products with financial ratings of “A” or better. These companies have been assigned that rating by independent rating agencies who scour the financials of these companies to evaluate their financial strength and their ability to withstand adverse economic conditions. With so many top rated companies offering competitive annuity products, there is little reason to consider companies with lower ratings. Consider starting your search at the top and then compare rates and fees.

Fixed annuities are long-term investment vehicles designed for retirement purposes. Gains from tax- deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply.

An Overview of Annuities

Most investors share the same goal of long-term wealth accumulation. Some of us have no problem watching our investments bounce up and down from day to day, while averse investors or those nearing retirement generally can’t withstand short-term volatility within their portfolios. If you are this type of investor – or one who has a moderate risk tolerance –annuities can be a valuable investment tool.

Today’s Annuities
An annuity is a contract between you – the annuitant – and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: you contribute funds to the annuity in exchange for the guaranteed income stream of your choosing later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years.

Most annuities offer tax sheltering, meaning your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them. This feature can be very attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments.

Because they are a long-term, retirement planning instrument, most annuities have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10-15% of the account to be withdrawn for emergency purposes without penalty. (Find out more, in Delay in Retirement Savings Costs More In The Long Run.)

How They Work
Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.

With an immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be a specified, fixed amount or variable depending upon your choice of annuity package and usually last for the rest of your life. Typically, you would choose this type of annuity if you have experienced a one-time payment of a large amount of capital, such as lottery winnings or inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age.

Deferred annuities are structured to meet a different type of investor need – to contribute and accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase.

Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions. (Learn more about retirement, in Guaranteed Retirement Income – In Any Market.)

Perks of Tax Deferral
it is important to note the benefits of tax sheltering during the accumulation phase of a deferred annuity. If you contribute funds to the annuity through an IRA or similar type of account, you are usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Also, any gains you realize in the annuity account over the life of the accumulation phase are not taxable. Over a long period of time, your tax savings can compound and result in substantially boosted returns.

It’s also worth noting that since you’re likely to earn less in retirement than in your working years, you will probably fit into a lower tax bracket once your retire. This means you will pay less taxes on the assets than you would have had you claimed the income when you earned it. In the end, this provides you with even higher after-tax return on your investment.

Retirement Income
The goal of any annuity is to provide a stable, long-term income supplement for the annuitant. Once you decide to start the distribution phase of your annuity, you inform your insurance company of your desire to do so. The insurer employs actuaries who then determine your periodic payment amount by means of a mathematical model.

The primary factors taken into account in the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your payments will be), the expected future inflation-adjusted returns from the account’s assets and your life expectancy (based on industry-standard life-expectancy tables). Finally, the spousal provisions included in the annuity contract are also factored into the equation.

Most annuitants choose to receive monthly payments for the rest of their life and their spouse’s life (meaning the insurer stops issuing payments only after both parties are deceased). If you chose this distribution arrangement and you live a long retirement life, the total value you receive from your annuity contract will be significantly more than what you paid into it. However, should you pass away relatively early, you may receive less than what you paid the insurance company. Regardless of how long you live, the primary benefit you receive from your contract is peace of mind: guaranteed income for the rest of your life.

Furthermore, your insurance company – while it is impossible for you to predict your lifespan – need only be concerned with the average retirement life span of all their clients, which is relatively easy to predict. Thus, the insurer operates on certainty, pricing annuities so that it will marginally retain more funds than its aggregate payout to clients. At the same time, each client receives the certainty of a guaranteed retirement income.

Annuities can have other provisions, such as a guaranteed number of payment years. If you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to the annuitant’s estate. Generally, the more guarantees inserted into an annuity contract, the smaller the monthly payments will be. (Read Counterintuitive Retirement Strategies That Work for more insight.)

Fixed and Variable Annuities
Different investors place different values on a guaranteed retirement income. For some, it is critical to secure a risk-free income for their retirement. Other investors are less concerned about receiving a fixed income from their annuity investment than they are about continuing to enjoy the capital gains of their funds. Which needs and priorities you have will determine whether you choose a fixed or variable annuity.

fixed annuity offers you a very low-risk retirement – you receive a fixed amount of money every month for the rest of their life. However, the price for removing risk is missing out on growth opportunity. Should the financial markets enjoy bull market conditions during your retirement, you forgo additional gains on your annuity funds.

Variable annuities
 allow you to participate in potential further appreciation of your assets while still drawing an income from your annuity. With this type of annuity, the insurance company typically guarantees a minimum income stream, through what is called a guaranteed income benefit option, and offers an excess payment amount that fluctuates with the performance of the annuity’s investments. You enjoy larger payments when your managed portfolio renders high returns and smaller payments when it does not. Variable annuities may offer a comfortable balance between guaranteed retirement income and continued growth exposure.


Annuities offer tax-sheltered growth, which can result in significant long-term returns for you if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity’s guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Finally, variable annuities allow less risk-averse retirees prolonged exposure to the financial markets. Be sure to consider annuities as part of your overall investment strategy, as they may add value to your retirement in more ways than you think. (Learn to plan ahead, in Retirement.)