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What’s wrong with annuities?

What is an annuity?

A tax sheltered annuity (TSA) is a mutual fund wrapped in an insurance policy. Thanks to the insurance policy, earnings inside the annuity grow tax-deferred. TSA sales representatives explain that the insurance will protect your investment, so if you die before you annuitize, your beneficiary receives either the current value of your annuity or the amount you paid into it, whichever is greater. The insurance doesn’t come free…which is what’s wrong with annuities.

What’s wrong with annuities?

Variable annuities are frequently criticized by retirement plan experts as inappropriate vehicles in 403(b) plans because of their high costs and hidden fees. Robert Brokamp in The Motley Fool August 2003 says:

“You’d be hard-pressed to find someone who is a big fan of annuities other than the people who sell them (for big commissions, we must add — usually bigger than the commissions associated with sales-loaded mutual funds). What’s wrong with tax-deferred annuities? Let us count the ways:

  • That insurance “wrapping” costs money — usually around 1% of the account value each year. Couple that with expense ratios on the investments in the subaccounts (which is what they call mutual funds within annuities) and 2.5% a year could be lopped off your return each year.
  • All the insurance does is guarantee that, upon your demise, your heirs will receive at least the amount of money you invested in the annuity. So, theoretically, you don’t have to worry about a market crash right before your death. Some policies will augment this benefit, for a price. For example, the “death benefit” might automatically increase 5% a year. But assuming the investor chose the annuity as a long-term investment (as any retirement investment should be), how likely is it that an account wouldn’t have grown at least 5% a year over, say, a decade?
  • Most annuities impose “surrender charges” that penalize policyholders who pull out of the annuity within a specified number of years. Typically, the penalty is 7% if the policy is cancelled within the first year, 6% the second year, 5% the third, and so on until the surrender charge vanishes.
  • While growth in an annuity is tax-deferred, contributions are not tax-deductible — unlike contributions to your work-sponsored retirement plan. Investors should always max out their 401(k)s and any IRAs they’re eligible for before considering an annuity.
  • Like other retirement accounts, if you withdraw money from an annuity before you’re 59 1/2, you’ll pay taxes and penalties. There are a few ways around this, but, generally, the majority of your money will be tied up.”

Numerous sources discuss this in detail. Financial Agency Regulatory Authority ( an agency of the United States Government has issued an investor alert about utilizing an annuity in retirement plans. See Investor Alerts, Annuities and Insurance,

In May of 2003, for example, the National Association of Securities Dealers1, issued an alert that stated:

“…Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA)/ (403[b]) may not be a good idea. Since (IRA)/(403[b])s are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.”

1The National Association of Securities Dealers was the legacy organization for the Financial Industry Regulatory Authority (FINRA), which is the largest regulator for all securities firms doing business in the United States. FINRA’s mission is to protect America’s investors by making sure the securities industry operates fairly and honestly.

For more of an eye-opening appreciation of the relationship between annuities and hidden fees, simply Google “hidden+fees+annuity.”

Fees, fees and more fees

Variable annuities are noted for the high fees they charge. Most tax sheltered annuity 403(b) plans have additional fees like these, which are generally referred to as “wrap fees:”

  • Administrative fee
  • Mortality and expense charge
  • Variable expense charge
  • Mortality and administration charge
  • Annual fee

You may not need the death benefit

The death benefit guarantees that your account will hold a minimum value should you die with less money in your account than what you contributed. This typically means that your beneficiary will at least receive the total amount contributed even if the account has lost money. However, when the cost of this feature is totaled up over time, the participant may be wiser to simply invest the additional assets in the plan. Generally, long-term market action should suffice to build up the investment. When you get right down to it, all of the additional fees that are included in variable annuities do not make a lot of sense. As a percentage, how many paticipants die with less money in their 403(b) plans then what they put in? Why pay for this benefit then?

Surrender fees

Another problem with most variable annuities is that your money is often locked up for several years. If you were to find a better vendor and wanted to move your money, you would be charged a penalty in the form of a surrender charge.

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