Allworth Co-CEO Scott Hanson shares an important "retiree beware" regarding one of the most popular - yet oversold - insurance products often aimed at retirees.
When it comes to your investments, it’s important to educate yourself about what you are buying, and why.
That’s because there are some popular investment products that might be reasonable for some people, but which are generally inappropriate for many of the people who end up being induced to purchase them.
Case in point: annuities.
Annuities are among the most oversold investments around. Atypically complex, annuities are contracts between you and an insurance company where you pay a lump sum of money in exchange for a periodic disbursement. These payments could be for life, or they could be for a pre-determined amount of time.
There are numerous types of annuities. Returns from a variable annuity may be dependent on the performance of a particular mutual fund; an indexed annuity is tied to a specific index (say, the S&P 500); and returns on a fixed annuity are tied to a particular interest rate.
As stated earlier, while an annuity may be an appropriate investment for some people, because they typically generate a great big commission for the seller, understanding the primary motivation of the person recommending the annuity should be a key consideration.
All things being equal, at Allworth Financial, we very rarely recommend an annuity. What follows are four reasons why.
1. The fees for variable annuities can be extremely high
Among the biggest drawbacks of variable annuities are the recurring fees. These are to pay for the risks and costs associated with protecting your money. As an example, an annuity fee could amount to roughly 1.25% of the amount you’ve invested.
Compared to variable annuities, however, the basic fees on both indexed and fixed annuities may be lower. Yet, when you purchase either an indexed or a fixed annuity, you’re likely going to be induced to add costly “riders” or expensive “customized enhancements” (such as death benefits or long-term care).
Fees aside, one of the most financially prohibitive aspects of annuities are surrender charges. You get hit with a surrender charge when you withdraw an amount of money over and above your regular payout. (Even if you need the money for an emergency.)
The amount of a surrender charge will tend to decrease the longer you have the annuity, but let’s say in “year-three” you have an emergency and you need to withdraw an extra $10,000. The surrender fee could well be a full 5% of the withdrawal, which means you’ll have to pay $500 just to get your own cash.
As a reminder, it isn’t only that a $500 penalty is expensive, it’s the fact that $500 deduction directly reduces the principal of your annuity account.
2. The returns on annuities don’t always match those received from the market
People invest in an indexed annuity with the goal that their interest returns will “match” those of an equity index. You’d think that would mean that if that specific index did well during a particular year, the returns on the annuity would also do well.
But that’s not necessarily the case. That’s because many insurance companies have this little thing called a “participation rate.” That means they “cap” your returns so that your investment can only grow by, say, 80% of the amount that the fund grew.
3. Breaking free of an immediate annuity could be impossible
The most basic type of an annuity, an immediate annuity, is a long-term investment product where you make a lump-sum contribution and it immediately begins paying you a guaranteed revenue stream (monthly, quarterly, or annually). Depending on your agreement, these payments could last for a few years, or they could continue for life.
A common, major drawback of most immediate annuities is that, once you buy one, you’re not only stuck with it, your payments can’t be passed on to a beneficiary, so the money stops flowing the day you die.
Some insurers might allow you to change your immediate annuity into a different category of annuity, but if this is even allowed, you’ll almost certainly get hit with some hefty fees and charges.
4. Annuities typically pay the seller high commissions
As stated earlier, buying an annuity typically means paying the seller a great big commission right off the top of your investment. In other words, you may not write a commission check directly to the salesperson for the annuity, but the money will be taken out of your deposit.
How much are these commissions? They can be 6% to 8%, or more. That means, that if you buy an annuity for $200,000, and the commission is 7%, only $186,000 of your money (before any other fees are deducted) is invested for you.
Besides their commissions, fees, and inflexibility (high surrender charges), here's a 'bonus' reason you should be wary of annuities: they have complex tax treatments. As just one example, the money you make from a deferred annuity is considered ordinary income and is taxed as such (rather than at the lower, much more tax-friendly long-term capital gains rate).
With all that in mind, if you still decide that an annuity is something you want to purchase, make certain you only work with an advisor who acts as a fiduciary 100% of the time (as all our advisors do). This will help you avoid conflicts of interest. Because there are advisors out there who only wear a fiduciary hat some of the time, their advice is almost certainly being influenced by the commissions they stand to make – and not by what’s best for you.
If you aren’t certain what motivates a particular advisor to make the recommendations that they do? Ask them whether they act in a fiduciary capacity 100% of the time. And if they don’t? Find yourself a new advisor.