The answer: Taxes and expenses.
As it turns out, an annuity is not the best way to go for most investors. Putting money into some other form of retirement account, like a 401(k), will almost always beat an annuity in performance over time, as will investing in mutual funds.
What Is an Annuity?
An annuity is a retirement plan sold by an insurance company or a brokerage house. There are two basic types: Fixed annuities pay a set rate of interest for a set number of years, and variable annuities allow for investment into an array of accounts that resemble mutual funds.
Investors can buy an annuity with a lump sum or make premium payments over time.
Only after-tax money can go into an annuity, but once it's in the account, it grows tax-deferred until it's withdrawn. By federal law, withdrawals taken before age 59 1/2 face a 10% penalty plus income tax. Unlike most tax-deferred retirement plans, however, you don't have to start taking taxable withdrawals at age 70 1/2.
Other Features of an Annuity
Sounds pretty straightforward so far, no? Well, hang on -- this is where the fun starts and the expenses pile up.
With most annuities, investors can opt at retirement to let their investments ride. They can also choose to convert the annuity into a lifetime guarantee of income or into guaranteed payments over some set number of years.
Most annuity contracts also come with other insurance-like features, including guarantees that your invested principal will never be lost.
Disadvantages of an Annuity
Producers get paid for all of those guarantees with a variety of fees, including "mortality and expense" charges, usually called M&Es. M&Es and other management fees are deducted each year from the value of your account, and they are substantial. In 2005, Morningstar pegged the average annuity's annual expense rate at 2.35%, well above the average mutual fund rate of 1.44%.
That alone is enough to wipe out any tax advantage that most investors might gain by owning an annuity instead of simply investing in taxable mutual funds.
But the downsides don't stop there.
Along with the annual charges, most annuities charge hefty surrender charges, which means they'll zap you with a fee if you change your mind and sell in the first years of your contract. A charge of 7% is not uncommon.
And then there are the tax consequences to your heirs. Although those who inherit taxable mutual funds get a tax-free step-up in value -- which also reduces their own tax bill when it comes time to sell -- the inheritors of annuities owe income taxes on any gains the annuity has made up to the date of death.
Advantages of an Annuity
You might benefit from annuity investing if you have maxed out your contributions to other types of retirement plans. It also might be beneficial if you need to shelter investments from a bankruptcy, you want to avoid probate, or you just can't do without that lifetime income guarantee. Most others should steer clear.