As a fee-only, fiduciary advisor, I’m not a fan of annuities.
That’s actually putting how I feel about annuities – and the people who sell them – lightly.
Specifically, I have a problem with the sale of fixed index annuities to vulnerable pre-retirees and retirees who want to create an income stream for themselves during their golden years. However, variable annuities aren’t that much better. There are a few rare occasions where an annuity makes sense, but those times tend to be the exception – not the rule. This isn’t what many insurance people, or brokers, will try to tell you.
Fixed indexed annuities are often sold by brokers and insurance salespeople with the promise of market upside and no downside. They’re only telling about 50% of the story with this claim, and I honestly believe most people selling these don’t fully understand them either. So, let’s break down what fixed index annuities are – and why they’re likely not the right financial fit for you.
What is a Fixed Annuity?
Fundamentally, with a fixed index annuity, you’re giving your money to an insurance company and in return, they’ll give it back to you – usually in monthly payments – for the rest of your life starting sometime in the future. That doesn’t sound so bad, right? Let’s investigate further.
Here’s how it works:
You “invest” your money into a fixed index annuity. Based on the terms of the contract, you will typically get some participation in the upside of the market, usually tied to an index like the S&P 500. Let’s say you get 80% of the upside – this is your participation rate.
But here’s the thing: unlike actually investing in the market, with a fixed index annuity, you’re investing in an insurance contract. That’s right – this isn’t even an SEC-registered or regulated investment.
Many fixed index annuities also have cap rates, meaning you get the market upside up to an annual return cap. These vary based on the contract, but let’s say it’s 8%. Since the market historically has returns that often fall below 8%, and a few years that can often be well above 8%, you’re potentially giving up a lot of upside, even though the fixed index annuity salesperson probably made it seem like you were capitalizing on all the upside available to you within your “investment”.
Finally, when you purchase a fixed index annuity, you need to remember that their version of “market returns” don’t include dividends. So these contracts are based on market upside, but you don’t get any of the market dividends which can comprise a meaningful part of the total return of the market over time.
It Gets Worse
Some annuity contracts pay the broker commissions ranging from 6%-10%+. To cover their sales department’s compensation, the insurance company may lock a client’s money up in the annuity for 6-10+ years. If you try to get your money out in year one, you might have to pay a 10% (or more) penalty.
The truth is that annuities (fixed rate or otherwise) are often complex and confusing. Even if I put the frustrating sales tactics that some brokers use to sell these products aside, they just don’t make sense for many investors – largely because they limit the client’s future flexibility and options.
Estate Planning Gets Messy
If the reasons above aren’t enough to send you running from the hills next time you get invited to a fancy steak dinner by a broker (more on that in a minute) – fixed index annuities themselves can cause a laundry list of estate planning problems. They don’t transfer smoothly (or inexpensively) to the next generation if they haven’t been annuitized before the annuitant’s death. For instance, an annuity that hasn’t begun making payments to the owner that is passed to a non-spouse beneficiary doesn’t get a “step up” in basis. Any growth or earnings on the original money put into the annuity is taxed at ordinary income rates.
Keep Your Eyes Open – Know the Signs
If annuities aren’t appropriate for most people, why do so many people keep buying them?
I’ve often asked myself the same question, and here’s what I believe to be the disheartening answer: Many people who are selling fixed index (and variable) annuities as a fix-all solution for retirement income either don’t fully understand what they are selling or are using smarmy sales tactics to make money. For themselves.
A marketing strategy some annuity brokers use is to invite middle class 60- and 70-year olds to a dinner seminar. They promise a free steak dinner or lunch, and proceed to terrify everyone in the audience by projecting horrifying future markets that “accurately account for” the state of the world order, and the impact of politics, terrorism – you name it! – on the stock market. They’ll attempt to convince everyone in the crowd that their money isn’t safe in traditional investment vehicles.
Then they trot out fixed index annuity products as the perfect, reliable solution. No downside, no market instability, getting to take advantage of market upside – what could go wrong?
Many rarely, if ever, point out all the fine print. They likely don’t talk about how your money will be locked up for the next decade in this insurance product, that they can be a nightmare to pass on to your heirs, that the actual returns you have access to are capped…the list goes on and on.
Have Questions? Get Fee-Only Input
Are you being targeted by a broker trying to sell you an annuity product? Before you make any moves that you may later regret, I would recommend consulting a fee-only advisor about all of your options. Fee-only advisors are compensated by the fees you pay them directly. They’re not making commissions off the sale of products that you may or may not need – like annuities.
A fee-only advisor has a fiduciary responsibility to provide advice they believe to be in your best interest. If you ever are questioning whether a financial product, or presentation you’ve sat through, is actually right for you, or if you’ve had someone try to sell your nearly-retired loved one an annuity product – contact me today. I’d love to help you explore whether the option is a fit for you, and walk you through the best way to say “no” if it isn’t.