By Joe Delaney
Too often, we’ve seen this all-too familiar story. A client brings in an annuity policy to review, either for themselves or a family member. They bought it to create a steady annual flow of income on later life, insurance against unexpected longevity.
But what we see is a jaw-dropping set of numbers that reveal poor performance, high commissions paid to brokers, misleading benefits and ridiculously high expenses.
How do so many fall into the trap of buying into an expensive annuity? There are a few key reasons.
Great for the Seller: Commissions
The first thing you need to be wary of as an investor is the possibility that a broker, or agent, is pointing you in the direction of a product more in their own interests than yours. Exhibit A is the annuity. An insurance product rather than a securities package, annuities are sold by insurance agents rather than brokers. It is sometimes the best option an insurance-only agent (not securities licensed) can offer.
There is nothing wrong with selling annuities in and of themselves, nor is there anything wrong with insurance agents earning commissions. However, when a product has particularly high commissions it is all the more important to ask the agent point blank whether annuities are in your best interests.
Strictly speaking, agents don’t have to act in your best interests because they are not subject to federal fiduciary rulesthat govern financial advisors. They also pay out among the highest commissionsin the financial service industry. The highest rates are paid for longer surrender periods, years during which policy holders are charged for withdrawals above the approved limit.
With so many common options that benefit the seller at the expense of the buyer it can be tempting for unscrupulous agents to talk up the benefits of annuities while omitting the risks.
Stability for the Buyer
The main benefit of the annuity is the option to guarantee a minimum return. Investors tend to fixate on the apparent risk-free nature of annuities as they plan to enjoy fixed payments after a pre-arranged waiting period.
In reality, this describes just one type of annuity, a fixed annuity. Similar to a Certificate of Deposit (CD), investors sacrifice the potential for a higher rate of return for the guarantee of a smaller one. Unlike a CD, there are generally complex fees and conditions attached to fixed annuities that reduce the value of the annuity more than it may appear.
For example, while tax is deferred while your annuity is accumulating, once you begin to withdraw accumulated funds you’ll have to pay taxes at your ordinary tax rate rather than the lower applicable long-term capital gains tax rate. (If you invested $100,000, your annuity grows to $150,000 and you’re in the 35% tax bracket, you’ll pay 35% on the first $50,000 you take out, 20% more than on capital gains at 15%.)
More Complex Options May Increase Return
Other types include indexed annuitiesand variable annuities. These appear to offer the potential for higher returns: indexed annuities, because the rate of return is tied to a specific market benchmark such as the performance of the S&P 500; variable annuities because they allow premium payments to be reinvested, somewhat like a mutual fund.
Unfortunately, these types of annuities often have performance capsto offset the risk the firm takes on by guaranteeing a performance floor. These can significantly reduce expected returns. Participation rateis another factor that limits what investors earn, as it governs what share of returns go to the firm and what share goes to the annuity holder. (For example, a 70% participation rate means if the market gains 10%, your gain is 7% while the firm keeps 3%.)
The above limitations on rate of return don’t even take into account the additional premium investors must pay for ridersto secure some of the benefits of these annuities, which further reduce actual return on investment.
Bottom Line: Insurance, Not Investment
We so often see actual annuity performance pale in comparison with a balanced portfolio of stocks and bonds; yet we routinely see “new and improved” annuities coming out all the time that insurance agents counsel their clients to convert into, via a 1035 tax free rollover, that serve only to fatten the agent’s wallet while further locking up a client’s ability to earn real income.
Investors are starting to wise up to this. Annuity sales saw a 17% dropbetween Q4 2016 and Q4 2015. (It is still a $51 billion industry, however, so investor beware.)
Does all this mean that you should definitely not purchase an annuity? No. What is important is to understand that while an annuity can act as a hedge against running out of income as you live longer, it is not the same as an investment portfolio geared toward the best possible return at the lowest possible expense.
What we are saying is that you should be cautious and always speak with an advisor bound by a fiduciary obligation to act in your best interests before you purchase any kind of annuity. If you have an annuity and you’re not sure what you have, or if you are considering an annuity and want to learn more about investing, please give us a call, the fiduciary advisors at Lifeguard Wealth.
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