There isn’t any type of investment or insurance strategy as polarizing as annuities.

Some representatives say “I would rather die and go to hell before I sold an annuity” and others will say “they’re the greatest thing since sliced bread.” 

This is due to a widespread misunderstanding, and frankly misuse, of what these vehicles are and how they should be implemented.

As a retirement planner, an annuity can be a wonderful tool for those looking to generate guaranteed retirement income. On the flip side, annuities can be a headache if used improperly or “sold” versus incorporated into a plan.

Before we get into the three annuity mistakes, here is a brief overview of the types of annuities out there:

• Immediate Annuities: This is where you give an insurance company a lump sum of money, and as the name suggests, immediately begin receiving a structured stream of income. This is called annuitization and the income payments will vary based on your age, gender, and the length of term selected for the payouts, usually 5 years to life. When you annuitize, you are giving up the principal and only have rights to the future income.
• Fixed Annuities: These are most similar to a Certificate of Deposit; in that you give an insurance company a lump sum of money, and they give you a fixed rate of return over an agreed upon time period. Like a CD, if you need to make an early withdrawal during that time period, there could be a penalty.
• Variable Annuities: These are essentially mutual funds invested through an insurance company, which are called subaccounts. Because of this, your account value remains subject to market losses, but also maintains the upside of the market. Just like investing in your 401(k), you can choose to be aggressive, moderate, or conservative.
• Fixed Indexed Annuities or Equity Indexed Annuities: This type of annuity acts almost like a combination of the above two. It has the principal guarantee of a fixed annuity, but also upside potential through the ability to earn interest based on the performance of the index it is linked to, such as the S&P 500.

Now that we know the types of annuities available, let’s look at three of the most common mistakes we see:

1. Know the costs: Annuities have all sorts of customization options or “riders” that you can attach to a contract to expand or restrict a policy’s benefits. These can guarantee an income for life without having to annuitize, add long term care features, enhance the death benefit, among many others. These typically come at costs in addition to the base contract costs. These can really add up, especially in a variable annuity which typically has sub-account fees, administrative costs, and mortality costs built into the base policy.
2. Understand the Time Horizon: It is never wise to put funds for shorter term needs into an annuity. Make sure you maintain adequate liquidity as annuities typically charge hefty penalties for violating early withdrawal terms. Also be aware of the liquidity provisions, as annuities may allow for a free annual withdrawal, allowing you to take an amount out that is not subject to penalties.
3. Understand the Risk and Growth Potential: You can’t expect to match market growth using Fixed or Fixed Indexed Annuities, and you can’t expect protection from market losses from a Variable Annuity. While a Variable Annuity can match market returns, Fixed or Fixed Indexed annuities act more like a bond component of a retirement plan.

Last, but not least, when you are evaluating if an annuity would be right for you, it’s important to find the most educated, unbiased opinion you can.

Look for an adviser who is:

1. Licensed in both securities and insurance, preferably who has a CFP®, ChFC®, or CLU® designation.
2. Acts as a fiduciary.
3. Represents multiple insurance companies.

Moral of the story: Annuities aren’t evil, but annuities also aren’t the greatest thing since sliced bread. They are simply another financial tool, and can prove to be a valuable component when creating a retirement income plan, if used in the right capacity.

Steven Paul is an Investment Advisory Representative at Richard Paul & Associates. Steve holds his life and health insurance licenses in Michigan and Florida. He is a Certified Financial Planner™ (CFP®) and completed the CFP Board required curriculum through Eastern Michigan University and Kaplan. He received his bachelor’s degree from Wayne State University, majoring in economics.