Deferred Annuities Don’t Build Legacy Wealth

As in most difficult economic times, commercial deferred annuities are being shopped as secure sources of long-term investment returns. But are they worthwhile? While there are no bright line rules, and this is in no way an attempt to give investment advice, from a legal perspective, in most instances the answer is “no.” I’ll break down how commercial deferred annuities work and why they don’t deliver on their promise.

How Commercial Deferred Annuities Work

The basic premise of a commercial deferred annuity is this: you give an insurance company your money and they agree to pay you a set interest rate on your money. While that is simple enough, the contracts actually make little or negative money for the first few years.

Each contract includes a “surrender charge.” The surrender charge is almost exactly the amount the insurance company is paying the broker—though most broker will not disclose this when selling the contract to you. The surrender charges say if you take money back in the first few years, you have to pay the surrender charge to the insurance company out of the cash value of the contract. The charge can be in the tens of thousands on a $250,000 contract.

The effect of the surrender charge is that a commercial deferred annuity with an insurance company is not profitable for several years into the contract. In addition, each year internal expenses are charged on the contract—often at a rate of more than 1% of the contract value. The expenses further reduce the investment growth in the contract even after the surrender charge ends.

Commercial deferred annuities are also sold as a tax-saving investment option, but they are not a tax-efficient as they are sold. While deferred annuities earn income on a tax-deferred basis, much like individual retirement accounts (IRAs), there is a significant tax trade-off for that benefit. Any money withdrawn before age 59 1/2 is subject to a 10% early withdraw penalty under Internal Revenue Code (Code) Section 72(q) on the amount of the withdrawal included in the holder’s income. Any withdrawal from the contract before it is annualized—regardless of when the withdrawal is taken—are treated as being paid from the income in the contract first under Code Section 72(e). Thus, non-annuity payments carry out taxable income, at the highest income tax rates, first. A payment as an annuity is simply the payment of a set periodic payment under the contract (usually a set annual amount) and the contract is annualized when it begins making payments as an annuity. The idea of most commercial deferred annuities, however, is that they will not be annualized for as long as possible in order to obtain the tax-deferred investment growth.

In some cases, these income tax rules apply to the annuity beneficiaries after the owner dies, making them less efficient legacy assets for building family wealth. First, if the contract has not been annualized, the general rule is the beneficiaries must withdraw all of the contract amount within 5 years of the holder’s death (the Five Year Rule). Second, if the holder named “designated beneficiaries” (who must be individuals), then one of two rules applies. If the designated beneficiary is the holder’s spouse, then the spouse gets to step into the holder’s shoes and continue deferring annuitizing the contract on the same terms as the holder could do. For any other designated beneficiary, the beneficiary has to withdraw the contract amount over the beneficiary’s life expectancy. Again, the payments not as an annuity carry out income first, off the top. All annuity payments carry out a mix of income from the contract and the investment (or basis) in the contract that is non-taxable.

Income from an annuity contract is taxed at ordinary income rates. The highest federal rate is currently 37%. That income is also typically taxed at a state, and potentially state, level, if the recipient resides in a state or city with an income tax. The combined highest California federal and state tax rate, for example, is 50.3%.

The contract also does not receive a “step-up” in basis at the holder’s death. Ordinarily, when a person dies, their assets receive a new tax basis equal to the fair market value on the date of death under Code Section 1014(b). This effectively resets the tax clock on the assset, eliminated any unrealized capital gains or losses in the assets an heir inherits. The beneficiaries of deferred annuities receive no such reprieve.

Finally, if a trust is the beneficiary of a commercial deferred annuity, the trust typically is subject to the Five Year Rule. Trusts, however, are powerful asset protection and legacy family wealth building tool. Consequently, when trusts are beneficiaries of commercial deferred annuities, to build legacy wealth they have to be invested in non-commercial annuity contract investments.

Why Does Anyone Buy Commercial Deferred Annuities?

Given these complexities, the generally low level of investment returns guaranteed by the insurance companies, and the at-death tax penalty of not receiving a “step-up” in basis, why would anyone buy a commercial deferred annuity for long-term investing?

The selling point on commercial deferred annuities is often that they will “never lose” money because the interest is “guaranteed,” while the exposure to the market would subject the investor to drops in value. There is no question market exposure has that effect occasionally, but when an investor has a long-term legacy view, the commercial deferred annuity sales claim falls apart.

The interests rates offered on commercial deferral annuities are usually well below the earnings of even conservative balanced portfolios. Vanguard conducted a study of different investment portfolios between 1926 and 2018 and found that a portfolio invested 60% in bonds and 40% in equities had an average annual yield of 7.7%, while experiencing 17 loss years out of 93. See This means that in about 82% of years, even these conservative investment portfolios the market won. These types of investment portfolios would also permit a “step-up” in basis on equities, granting beneficiaries up to a 23.8% federal tax savings at the investor’s death.

As discussed above, due to surrender charges a purchaser of a commercial deferred annuity is not “in the money” for years, and therefore the contract has a self-imposed guaranteed market “drop” instantaneously upon purchase. And the drop is often not clearly explained to the buyer nor explained for what it is–taking money out of the buyer’s pocket and putting that money in the broker’s pocket. Second, even when Vanguard looked at 100% bond portfolios, the average annual return was 5.3%, with only 14 loss years out of 93. The worst loss year was 1969 with a loss of 8.1%. These bond-only funds thus had a win year 85% of the time and never lost more than 8.1%. Compare that to the guaranteed loss in the first few years of a commercial deferred annuity with a single premium of $500,000, paying $30,000 in surrender charges (6% of 500,000), plus annual fees often exceeding 1% (and frequently by a multiple of 3 in variable annuity contracts). In the annuity context the buyer is agreeing to a 100% chance of the loss years in the first few years in exchange for consistent, but often much lower investment income thereafter (when they are back to zero). In the meantime an investment in even a conservative portfolio of 60% bonds and 40% equities would have yielded 7.7% (historically) during each of the first few years when the commercial deferred annuity was underwater.

If one is sold on commercial deferred annuities because of the guaranteed interest rate, there are better ways to achieve those goals under the tax rules. Often the guarantee is sold as unquestionably good due to the economic strength of the insurance company. The company can guarantee all it wants, and there are some very financially healthy insurance companies, but no insurance company has the financial viability of the entire market. In fact, the insurance companies use the premiums received on products like annuities to invest in the market themselves. See

For building legacy wealth and long-term investments, commercial deferred annuities just do not deliver on their legal promises.

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