Annuities: Guaranteed Return? Take a Closer Look!

By: Thad Ismart, CFP® | Senior Financial Planner

Planning for retirement can be stressful, especially when you see huge swings in the value of your retirement and investment accounts. It is during these times of volatility that investors are often presented with investment opportunities that may seem too good to be true — and frequently they are.

If you have not been bombarded with sales pitches from investment professionals selling annuities, then you are one of the lucky few. While annuities may have some benefits, they are often not appropriate for investors, and they have several significant drawbacks that should be carefully considered before determining whether annuities are a suitable investment vehicle to accomplish your financial goals.


When purchasing an annuity, you typically make a lump sum payment into an account with an insurance company. The money is invested during a period known as the “accumulation phase.” At a later time, you can either receive distributions as an income stream or as a lump sum.

However, the many fees associated with annuities can reduce your investment return. These fees include commissions paid to the broker who sold you the annuity, fees for transferring investments within the annuity, administration and management fees, mortality and expense fees, and surrender charges.


When purchasing an annuity, you should be aware that the investment professional who sells you the annuity is typically paid a large commission by the insurance company, often up to 10% of the cost of the annuity. The insurance company does not want to lose money should you surrender your annuity within the first few years. As a result, insurance companies impose surrender charges if you surrender your annuity, typically, within seven years. For example, an insurance company might impose a 7% penalty if you surrender your annuity in the first year, 6% penalty in the second year, 5% in the third year, and so on. After seven years, you can surrender your annuity without penalty.


Just as with any investment, there are no guarantees with annuities. But, if there are no guarantees, then what about the “guaranteed” rates of return on annuities offered by insurance companies? These so-called guaranteed rates of return are misleading. Let us assume you buy an immediate annuity (an annuity that begins to pay you immediately and is not invested) for $500,000, with a guaranteed 6% rate of return. This means that you would receive $30,000 per year for the rest of your life. This sounds great… until you dig a little deeper.

The annuity does not actually have a 6% return. When you purchase an immediate annuity, you are agreeing to give an insurance company a premium ($500,000) in exchange for a guaranteed income stream ($30,000 annually). After you purchase the above annuity, your $500,000 investment is gone — you have paid it to the insurance company. So for the first 16 or so years, the insurance company is only giving you back your own money (your initial premium).

Annuity brokers will often describe annuities as “investments,” to discourage investors from thinking about the loss of their premiums. We do not consider an immediate annuity an investment, simply because you do not have access to your initial premium of $500,000.

What about variable annuities? Many of us have heard investment companies, on television and the radio, offering guaranteed rates of return on retirement accounts. They often point to the volatility in the stock market and purport to offer ways to protect your principal. But how is this possible?

These rates of return are only guaranteed for an “income account” or “withdrawal value,” they are not the rates of return on your investment. A variable annuity has two accounts. The first account is called the sub account. This is the account in which the premium you paid the insurance company is deposited. It is typically invested in a portfolio of stock and bond mutual funds. The value of the sub account will fluctuate as the underlying mutual funds fluctuate in value, just as in a typical investment account.

The second account is called an “income account,” and its initial value typically equals the initial premium paid. However, the income account is the only account that falls under the guaranteed rate of return. The income account will increase in value by the greater of (a) the appreciation of the underlying mutual funds in the sub account, or (b) the guaranteed rate of return. It is important to note, however, that the annuity owner does not have access to the income account and the guaranteed rates of return. He only has access to the sub account. The income account is simply an account value used to calculate your withdrawal amount when you begin receiving income from your annuity.

Let us assume you buy a variable annuity for $100,000, and your investment return in the sub account is 4% each year for the next ten years. Let us also assume your annuity offers a guaranteed rated of return of 6%. The sub account would grow to $148,000, based on the 4% return. However, your income account would grow to $179,000, based on the 6% return.

Having the 6% return when the market has only returned 4% sounds pretty good, right? At first glance it does, but you then you read an article about variable annuities. You speak with your financial planner, and you conclude that a variable annuity is not appropriate given your financial goals. When you ask the insurance company to surrender your annuity, you will get the value of the sub account ($148,000), not the “income account” ($179,000). The guaranteed rate of return applies strictly to the “income account” which only comes into play later when the insurance company uses its value to calculate your annual income benefit, if/when you decide to turn on (or annuitize) your income stream.

There are many ways to generate an income stream in retirement. While annuities may be appropriate for some investors, there are usually more cost-effective and efficient investment vehicles available to achieve the same goals. At the risk of sounding cliché, if something sounds too good to be true, it probably is.