Today’s fixed annuity products possess great intrinsic value (e.g., tax deferral, guaranteed income options, probate avoidance and others), but they come with drawbacks that a buyer must understand before committing their hard-earned cash.
In my view the drawbacks are not deal breakers but must be carefully considered by the buyer before the products are purchased.
The key fixed annuity product drawbacks are:
1. Interest Rates That Can Change Each Year
Most fixed annuity contracts (except for multiple year annuity products, where the interest rate is guaranteed for the entire surrender charge period) allow the issuing life insurer to set a new interest rate each year or period of years. This means that the interest rate the consumer receives can change during the surrender charge period. This is an implicit risk the consumer is taking when buying most fixed annuity contracts.
This impact of this drawback can be minimized by understanding the renewal rate history of the issuing life insurance company. Most all annuity companies will provide a documented record of their renewal rates as a historical indicator of how the carrier has treated consumers when setting renewal rates.
2. No Capital Gains Tax Rate
Income earned on fixed annuity contracts is treated as ordinary income and not as capital gain. For example, suppose a fixed annuity contract is purchased for $25,000 and the contract is fully surrendered 10 years later when its value is $50,000. Based on current tax law, the gain on the contract of $25,000 will be treated as ordinary income and taxed at ordinary income rates in effect at the time of withdrawal. The benefit of being taxed at likely lower capital gains rates is not available.
3. Contractual Bonuses That Come With Strings Attached
Many fixed annuity contracts are sold with what are advertised as first-year bonus interest of 3% to 5% for example. The buyer should know that for most contracts, to fully earn these bonuses, they will need to hold the contract for several years, or, in some cases, they will only get the bonus if they take an income stream from the contract.