Annuities:  The most misunderstood financial products

Annuities are the most misunderstood product in the world of finance. In my office, rarely does a month go by that a client, or potential client, does not sit across from me and express their confusion about an annuity account.  

Annuities are rarely bought, but often sold.  That is, people rarely develop a financial plan, determine that an annuity is just the thing for them, and go annuity shopping. Rather, as they are talking to a “financial planner,” “banker,” or “insurance agent,” they may hear a key word that they value, like guarantee.  They trust the person or institution presenting the annuity, and are sold an annuity contract based on that trust.

In a nutshell, an annuity is a whole life policy that pays benefits over a period of time rather than upon one’s death.  It should come as no surprise that annuities are a product created by the insurance industry, not by financial institutions, thus in years past, annuities were only sold by insurance agents.  Now the rules have changed, and banks and insurance companies operate in tandem again.  Consequently, when many unsuspecting and uninformed people walk into the branch office of their local bank to renew their Certificate of Deposit, they find themselves directed toward the in-house “agent” who appears to be a bank employee, who sells them an annuity instead.  Based on my experience, these unsuspecting customers are often female, elderly or both and rarely knew they were buying an insurance product. 

Annuities come in three types: Variable deferred annuities, Fixed deferred annuities and Income annuities.  Here is a summary of annuity options with their advantages, when to consider an annuity and their investment options.

Type of annuity	Variable deferred annuity	Fixed deferred annuity	Income annuity
Main advantage	·         Deferral of taxes on earnings ·         No required minimum distributions at age 70˝ (on non-qualified assets)	·         A guaranteed, tax-deferred interest rate over a specific period, usually one or five years	·         A stream of fixed, variable, or a combination of fixed and variable income payments during retirement
When to consider	·         If I am a long-term investor who has contributed the maximum to other tax-favored accounts, and taxes are a factor in my wealth accumulation plan	If I am an individual looking for the security of a fixed interest rate	·         If I want to reduce my risk of running out of income during retirement
Investment options	·         A selection of stock, bond, and money market portfolios	·         None. Your money goes into the issuer’s general fund	·         A selection of stock, bond, and money market portfolios, or a fixed account in the issuer's general fund

Looking at the table above, it is hard to see why everyone wouldn’t want an annuity.  However, there are strings attached.

First, annuities are insurance contracts, and they come with all of the accompanying commissions and fees.  As with all insurance products, these fees and commissions are hidden inside the product.  Due diligence is required to wade through the lengthy and technical contract to find them.

Second, annuities almost always have significant termination fees.  That is why insurance agents normally refer to them as “seven-year products.”  The hidden message is, if you decide you want your money back over the next seven years, the insurance company will charge a surrender fee that can be as high as 10% and is rarely less than 7% of the value of the account.  Each contract varies, so one has to be diligent and read the fine print.

Third, purchasers of annuities get hypnotized by the word guarantee. Some features of some annuities are guaranteed.  Too often, the guarantee is misunderstood or is insignificant to the total picture.  

For example, I often see clients who have purchased variable deferred annuities because of the guarantee.  Usually in these types of contracts, the only guarantee is that when you die, your estate will not get less than you paid for the annuity.  Think about this for a minute.  Looking at the above chart, a variable deferred annuity gives you the option to invest in a mix of stocks, bonds and money market accounts. We all know that stocks and bonds go both up and down in value every day.  Yet your intention with investing is for your portfolio to increase over time.  So if you invest with a solid asset allocation plan over the long term, it is unlikely that you will have less than you started with.  It is possible, but unlikely.  Yet every year you pay an insurance fee to guarantee your death benefit!

In a fixed annuity, the interest rate paid by the contract is guaranteed for a set period.  Often, the initial interest rate is significantly higher than the current market rate.  This is a good way to lure you in.  After than initial period, however, often just a year, you are stuck with an insurance contract with a steep surrender charge that now pays a lower return than the current certificate of deposit!

Don’t get caught up in the word “guarantee”. Investigate what is truly guaranteed and determine if this guarantee has any value to you.  Also, remember that the guarantee is issued by the insurance company, not the financial institution, so be sure the company you are purchasing the annuity from is solid.

The development of a solid and sensible financial plan has a greater impact than any other single action in creating a life of wealth and prosperity.  One significant benefit is that once you have done that, you can then make informed decisions and invest in products based on a sound plan centered on your personal goals and objectives, rather than taking the risk of being sold a product that does not serve you. 

Reprinted for the Sunday Challenger, July 3, 2005.  By: Mackey McNeill