Are Annuities Ever a Good Investment?
David K. MacLeod, CFP®, CFA
Income and safety for the rest of your life. Doesn’t that sound nice? Annuity salespeople will make these offerings sound like the ideal investment for a peaceful retirement.
However, before you roll over your 401(k) or IRA nest egg to an insurance company, you’ll want to do your homework to avoid a mistake. Buying an annuity can be an irrevocable decision for the rest of your life, so it’s important to proceed cautiously.
Buying an Annuity: Insurance or Investment?
One common misconception about this product is that they’re a traditional investment vehicle. In fact, they are a contract with an insurance company. Most of them are not regulated by the U.S. Securities and Exchange Commission (SEC), and they are not considered regulated investment vehicles by the SEC. Rather, most annuities are regulated as an insurance product by state insurance commissioners.
Annuities are better thought of as insurance to hedge longevity risk, or the risk of living longer than expected and running out of money. But by the nature of being locked into a complex contract with an insurance company, there can be serious disadvantages.
So, is an annuity a good idea for you? Probably not. You likely already have one in the form of Social Security or a pension. It rarely makes sense to buy a private annuity from an insurance company—and I’ll share some of the reasons why in this article.
Annuities Are Sold Products
Have you ever heard the expression “If you are a hammer, everything looks like a nail?” The thought is that the hammer can do only one thing, and it sees everything in the context of that vision.
Salespeople are paid very well every time they sell an annuity, so they tend to see these products as the solution to many different financial problems.
Do you need income? Buy an annuity. Do you need to pay less in taxes? Buy an annuity. Do you need financial security? Buy an annuity. Do you need better investment returns? Buy an annuity.
Annuity salespeople are some of the highest-paid salespeople in the financial world, so the best salespeople are attracted to the business of selling them. Thus, these people are extremely persuasive in explaining how the purchase of one will solve your problems. Yet, this is rarely true.
Annuities Are Expensive
When a $100,000 lump sum annuity is sold, the salesperson usually is paid upfront between $5,000 and $7,000. And, if the product sold is, for instance, five times bigger ($500,000), the sales commission goes up proportionately five times to $25,000–$35,000.
The reason that companies can afford to pay so much in commissions is that they charge high annual fees and early surrender charges. Annual fees are usually in the range of 2% to 2.5% each year. Early surrender charges of up to 15% can be in effect for over 10 years and are designed to protect the upfront sales commission the salesperson earned.
Annual fees are collected no matter what happens to the value of the annuity. They’re usually charged in the background of the product, rather than appearing on a statement, so it’s hard to see how much the owner is paying. You can find details in the prospectus, but it’s often like trying to read in another language.
A Big Bet on an Insurance Company
As stated above, annuities are a contractual agreement where the purchaser is paying for financial results from a financial company.
True, annuities are offered by only life insurance companies and are regulated on a state-by-state basis, but that regulation does not necessarily make annuities safe or guaranteed. You can lose money on annuities, and sometimes insurance companies go out of business, with annuity holders being left with less than they thought they would receive.
When you buy an annuity, remember that you are taking on a concentrated risk with one company.
Annuity “Returns” Can Be Misleading
Often, you’ll hear promises of 6 percent (or more!) safe annual returns from annuities. Unfortunately, this figure is actually a payout rate that isn’t comparable to an investment rate of return. An investment return can be calculated using a spreadsheet or financial calculator. The calculation requires knowing the payout rate and estimating when the annuitant will pass away.
For example, a 65-year old male asks an insurance agent for an immediate annuity quote on $1,000,000. Let’s assume he is quoted a 6.3% “return” (payout rate), or $5,250 per month for the rest of his life. Assuming normal life expectancy of 19 years to age 84, the investment rate of return for this annuity is equal to 1.9% annualized. If this person lives to age 90, the investment rate of return increases to 3.9% annualized. This man would need to live another 51 years (to age 116) in order to earn a 6% investment rate of return.
When comparing an annuity payout rate with an investment withdrawal rate, it’s also important to note that the immediate annuity amount will not increase with inflation. This means your annuity payments will be worth less in the future. This is another common misunderstanding when considering an annuity.
Annuities Are Hard to Exit
The high commissions paid for annuity sales are, of course, the powerful motivation behind the advertisements and sales tactics used by salespeople. The high commissions are also the reason that annuities have surrender penalties. Some surrender penalties last for seven years, but rather egregious annuities exist with surrender penalties that last 15 years!
The surrender penalty is the process by which the annuity company gets paid back for the big commission they paid to the salesperson. If they are going to pay such high commissions, they want to get reimbursed if you get out of the contract after one year. The surrender penalty is the way the company makes you pay for the commission they fronted.
Annuities Are Complex
Annuity contracts are a prime example of just how creative lawyers can be if they are motivated. The contracts are complex and are mostly written to the benefit of the company. The complexity makes the product hard to understand by the typical purchaser and tends to overwhelm even people with the smartest of minds. For example, one of the top sellers in California comes with a 1,096-page prospectus (no joke!).
Annuities are sold as the answer to many problems: guaranteed income stream in retirement, high returns, tax savings, easy withdrawals, etc. But, when you dig into the details, you often find that the buyer would be severely penalized if any tiny misstep was taken.
Annuity Offerings: Hype vs. Reality
Although annuities are often sold as the best answer to every financial problem, they are not. A little information can show almost anyone that they have other options for their money that cost less, have better returns, are more flexible, and save more on taxes.
Annuities tend to prey on people’s fear of the unknown. The guarantees offered by the company seem to eliminate all the fears that the purchaser has. But our financial advisors have found that if we educate our clients just a little bit about these products and the other investment options they have for their money, annuities don’t sound quite as good.
Every investment has an element of risk. Annuities might be sold as eliminating risk, but they just trade some risks for other risks. Commonly, the new risks are overpaying for financial results, incurring penalties to get to your money when you need it, being unable to stay ahead of inflation, losing assets due to corporate bankruptcy, and lacking asset growth in good financial markets.
A comparable diversified allocation of investments using mutual funds or exchange-traded funds (ETFs) can provide lower costs, avoid penalties, offer daily cash liquidity, give the ability for higher returns, provide a good fight against inflation, can be tax-efficient, and avoid dependency on the promises of a single corporation.
What If You Already Own One?
Don’t beat yourself up. It’s not the end of the world. Annuities are far from ideal, but if you own one or many, you have ways to get out of them and move to better solutions. The details of your contract will dictate the options you have, and there are some fee-only financial advisors who have the expertise to help you understand those options.
Our Fullerton financial planning firm has helped hundreds of clients understand and avoid the pitfalls of annuities, so you might want to have us take a look at yours. There isn’t a silver bullet that solves every problem, but we will help you understand the best options you have.
Always Know How a Financial Professional Gets Paid
Maybe the most important message about avoiding annuities is that we all need to understand how people in the financial world get paid. It helps us understand the motivation they have for the advice they are giving.
If a financial professional gets paid a commission when you sign a contract, then they might only be worried about you signing the contract and not thinking of your best interests in the long term. They are not a fiduciary. Rather, they are the hammer, and you are the nail. Ouch!
Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.