Insights & Advice

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Don’t be fooled by Annuities

Given the volatility of the stock market over the last few weeks, it is no surprise that annuity and life insurance salesmen, brokers and financial advisors are once again touting the wonderful benefits of fixed and variable annuities. Don’t get sucked into their sales pitch because the facts are that annuities only make sense for a tiny fraction of the population.

A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract that is designed to protect you from a loss of capital. Because it is sold under the name “insurance” the earnings inside these annuities grow tax-deferred like an IRA or 401(K), but are not subject to annual contribution limits. Withdrawals after the age of 59 ½ are taxed as income and early withdrawals are subject to an additional 10% penalty just like other tax-deferred accounts.

Many fixed annuities promise a guaranteed rate of return, no matter what the stock market does. Others offer both a guaranteed return (usually lower than the going rate on CDs) while also offering investors a piece of any upside gains in the stock market. Most annuities also come with a death benefit which guarantees that your account will hold a certain value should you die before the annuity payments begin. That means that your beneficiary will at least receive the total amount you invested, even if the account has lost money.

Given all these wonderful attributes, “What’s wrong with annuities?”

Nothing is as simple as it appears. If you have the time, knowledge and perseverance to wade through all the paperwork that accompanies these investment vehicles, you realize that all of them have “gotchas”. “Gotchas” are the fine print, exceptions and caveats that come along with these guarantees and promises.

Be aware that annuities are long term investments, usually 20 years or more. Yet, rarely do investors realize that once in, it is expensive to get out. There are penalties or surrender charges you pay in the event you change your mind and decide to sell. These could be as high as 10% if you sell early within a year or two and gradually drop until most (but not all) annuities allow you to exit after seven to ten years without penalties.

The selling pitch that annuities will go up in value if the market rises but are insured against losses if the stock market falls is compelling. It sounds like a free ride and that’s what should tip you off. Read the fine print. You will usually find that part of the contract will only be honored if the investor dies; otherwise you lose with the rest of us on market down days.

Annuities may do fairly well in protracted periods where both stock markets are down and interest rates are low but those circumstances rarely occur together. They do poorly in times of inflation, especially fixed annuities, or in times of high interest rates or strong stock markets. Overall, annuities’ performance has been sub-par but that’s not what the broker is selling.

In volatile times like these, the financial industry, like sharks in bloody water, will capitalize on the fear investors are experiencing, especially among the elderly or those already in retirement. Never buy an annuity because you are afraid of the financial markets. If the guarantee is what attracts you to the annuity, you should take a hard look at the insurance company behind the product. How healthy is the underwriter? A number of insurance companies have had financial problems and not all of them are pillars of safety even today.

Never buy a tax-deferred annuity in another tax –deferred account such as a Traditional IRA, Roth IRA, 401(K) or other retirement account. In doing so, you are getting no added tax benefit and are adding an insurance expense. It’s like wearing suspenders with a belt.

Finally, readers should understand that annuities generate huge fees for brokers and agents. The commission and fees can be 10% of the amount you invest or higher, far more than commissions paid on stocks and mutual funds. Annuities also provide the broker or advisor with an income stream for years to come, which continues to drain your investment. Naturally, none of these fees are included when the salesmen are touting the annual rate of return of your annuities. The harsh reality is that it will take investors several years just to break even on this investment after fees.

Ask yourself how relevant the annuity is to your financial goals and whether it truly is the best solution to your needs. Chances are it won’t be. Most risk-adverse investors would save a lot more money and be better off by simply buying several certificates of deposit with different maturities. They pay as much as guaranteed fixed annuities; and if you do want some exposure to any potential growth in the stock market simply buy a few mutual funds.

Remember that no matter what that broker says, annuities are not risk-free investments. They are illiquid, subject to interest rate and market risks, counter-party risk as well as burying you under a mountain of fees and expenses.

Posted in A Few Dollars More, Financial Planning