Of the entire spectrum of financial tools and products that have been available to investors over the last several decades, virtually none of them have been so polarizing as annuities. In theory, they are attractive options for retirees looking for a consistent income stream often times supplementing a pension or Social Security. Yet there is no shortage of articles both on the Internet and in print advising would-be annuity owners about the many pitfalls of these instruments. Some commentators offer cautious, thoughtful insight into the pros and cons of annuities. Others are not so reserved.
It is no surprise then that I meet with people all the time who are interested in adding an annuity to their retirement portfolio. However, they have met with so many conflicting opinions about them that they have no idea what to believe. They like the idea of an income stream they can’t outlive—who doesn’t? But they have heard so many negative statements that they are hesitant to own them in some cases and downright opposed in others. So, what gives?
Looking back at my interactions with pre-retirees and retirees, who have had less than sterling opinions of annuities, I’ve started to see a few patterns that I believe have led to the confusion and misunderstanding of these investments. And just to be clear, I don’t love or hate annuities, just like I don’t love or hate flour; however, I can’t only use butter, sugar and eggs in a recipe without the flour or my best laid culinary plans aren’t going to amount to much.
As a result of combining the different features of various types of annuities to the point of one complex, confusing and unattractive product, I firmly believe that the vast majority of concerns over annuities are misguided. Recently, a client told me they weren’t interested in purchasing an annuity because they didn’t want to tie up their money for 20 years (which isn’t an option for any product that I’m familiar with), they didn’t want to pay the high fees, or they didn’t want the insurance company to keep all of their money when they die. This sentiment stems from combining the negative attributes from three completely different kinds of annuities and merges them into one unattractive product.
The spectrum of annuities and their features is about as broad as the spectrum of motor vehicles. To say that a SINGLE vehicle can get 50 miles per gallon, tow up to 10,000 pounds, and reach speeds of 200 mph would be false. However, to say that some vehicles can get 50 miles per gallon, some vehicles can tow up to 10,000 pounds, and a few vehicles can achieve speeds of 200 mph would be true. Annuities have been around for over a hundred years, and they come in all shapes and sizes, each with a certain function and their individual pros and cons. Unfortunately, many investors (and brokers) have taken elements they know to be negative about annuities and ascribed them to all of these products.
While most of the negative things that people have heard are true for some annuities, they certainly are not true for all annuities. Here is an outline of some of the primary complaints that I have run across, as well as an explanation of when and where they are relevant:
- Annuities have high fees. This is typical of variable annuities. These annuities are the only types where the premium you invest can be directed into individual mutual funds and other investments. These annuities tend to carry higher fees than individual investments (often >3%). However, these fees go not only to pay for the internal costs of the investment, but in many cases, can help ensure an income stream as well.
- Annuities tie-up your principal for a long time. This is true of many fixed annuity contracts. Often times, annuities have surrender schedules of 10+ years and can span as long as 16 years. However, many other types of annuities offer return of premium options, making your investments liquid in as little as one year.
- In some cases, if you die early the insurance company will keep all of your money. This is true of many older annuities. At one point, it was common for companies to annuitize a contract, basically, creating a private pension out of your savings. However, upon death of the annuitant, the payments ceased and the insurer kept the remaining principal. Although these policies do remain in existence, they are becoming exceedingly rare. Most annuities today pass on any remaining capital to beneficiaries.
- Some annuities severely limit your upside potential. This is true of fixed-rate annuities. Most pure fixed products are paying interest in the 2-3% range. This is a slightly better rate than most CDs, but it barely keeps pace with inflation. However, indexed and variable annuities allow you to participate both directly and indirectly with market performance. What’s more, some of the most recent contracts don’t limit or cap your upside exposure to the market at all. Rather, they charge a spread—similar to a fee-based investment service—allowing the client to have much more upside potential in bull markets.
- Annuities may cause you to lose control of your money. Many people fear tying up their money, no matter how short the given period of time, in case of emergencies or dire need. While some older annuities make it hard to access all of your funds, many new products allow for penalty-free withdrawals as high as 20% in a given year. In addition, most have clauses that waive surrender fees in the cases of critical or terminal illness, required minimum distributions, or long-term care.
- Annuities just aren’t good investments. As I mentioned earlier, variable annuities typically offer the types of investments that most brokerage accounts offer but with higher fees. However, what you get in exchange is a guaranteed income stream from these investments. As always, guarantees and principal protection apply to certain insurance and annuity products (not securities, variable or investment advisory products) including optional benefits, and are subject to product terms, exclusions and limitations and the insurer’s claims-paying ability and financial strength of the issuing insurance company.
So, it becomes a matter of what is more important—safety or growth, and how much you are willing to pay for it. But what about annuities that claim to offer market-like growth with no risk to principal? Too good to be true? No. The landscape of investment services and products is constantly evolving, and to stay competitive, insurance companies are perpetually enhancing their products. Industry competition breeds new features and better products, which in turn, benefits the consumer.
Yes, there will always be some price to pay for downside protection and/or guaranteed income. As they say, there is no such thing as a free lunch. Every investment under the sun comes with some type of trade-off and annuities are no different. They each have their strengths and weaknesses. If you are interested in purchasing an annuity, the key is to assess each one for their intended role, analyze them objectively, and compare them to your other alternatives for each situation. All investments are tools, and some are better for certain jobs than others. The secret is having the right tool for the right job.
Insurance products, including annuities, offered through Jason Weckel. Life & annuity licensed in Tennessee. License # 2275586.
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