I don’t know if it’s just my imagination but it seems to me with each volatile streak in the stock market, annuity sales pitches become more prevalent on the radio.
You may have heard them pitched as a “personal pension” or “your money is guaranteed to go up and can never go down”. While these sound like great concepts, the most skeptical among us might react with “If it’s too good to be true, it probably is….”. And it is of course, it is too good to be true. Given this backdrop, I believe it would be helpful to walk through some basics of annuities and provide some perspective. I believe my view can easily be summed up by the title from the classic 1966 western starring Clint Eastwood called, “The Good, The Bad & The Ugly”. But I want to change up the order of my opinions in order of priority as I think about annuities: “The Bad, The Good & The Ugly”. Given the length of each list (below) most readers can probably guess where I usually come out on annuities.
But before getting into that, I’ll first define an annuity in the most basic terms. An annuity is a contract you sign with an insurance company, usually to exchange a good chunk of money for a promise of future payments. Now there are many, many variables that get applied to this agreement- from the underlying investments, to the time period for payment, to the time for payments to start, to who might get paid if the annuitant dies, etc. Despite all the variances, it’s a contract between you and an insurance company.
Example: a 60 year old male, who wants payments to start immediately, might plunk down $250,000 in exchange for lifetime monthly payments. How much will that buy him (according to immediateannuities.com)? About $1,245 / month for the rest of his life or a payout of about 6% per year. Not bad right? Well, read on for The Bad, The Good and The Ugly:
Your Money Is No Longer Liquid: Once you sign up for most annuities, you’re turning over a large chunk of change for future payments. However, once your money is with the insurance company in most cases, you no longer have easy access to it, and neither do your heirs. If an emergency comes up and you need your money back, the contract usually stipulates there are onerous “surrender charges” of 10% or higher for somewhere between 7 or 10 years! Also, if you were to spend $250,000 for some types (not all) annuities and drop dead in a year, your heirs get $0 (or a very small death benefit).
Usually Expensive with Conflicts of Interest: Most annuity salesman will say “you don’t pay me, the insurance company does” but do you really think the insurance company would have the same payouts for their annuities if they didn’t have to pay some guy 5%, 6% or more UPFRONT for your annuity (that would be $12,500 payout on a 5% commission for $250,000 annuity). Not only that, do you really want to ask an annuity salesman (usually posing as a financial planner) for advice on whether or not it’s a good idea to buy an annuity if he has a $12,500 payout hanging in the balance?
Limits on investment returns in exchange for “not going down”: You may hear “your money is safe and it goes up with the stock market but is guaranteed to never go down”. This has two nefarious aspects to it:
- Nothing is guaranteed: I don’t care what any insurance company says- nothing is guaranteed. If an insurance company goes out of business because they were selling high-payout annuities and could not make good on those payments, then you are out of luck. There are no guarantees.
- When your money “goes up” with the stock market, your “upside” is usually capped and you don’t capture all the gain. So yes, your money won’t go down but if the stock market goes up 16% (like it did in 2012) or 30% (like it did in 2013) or 14% (like it did in 2014) your money can “participate” and go up but could be capped at something like 8%. Who pockets the gain on your money above 8%? The insurance company. Given the market has gone up 71% of the years between 1825 and 2013 AND only 26 of 189 years did stocks finish down more than 10%, who wins that bet most of the time? I’ll give you one guess.
Ever hear this on the radio?
Annuities are Complicated: Ever see an annuity contract? It looks like a small print version of Tolstoy’s War & Peace. Why do you think that is? To clearly communicate the costs and benefits to you? As usual, the devil is in the details on these contracts and the more complicated the details, the less able we are to adequately judge the value.
Despite all the bad attributes, annuities CAN, in limited circumstances, serve a purpose for some people.
“Peace of Mind”: One could argue there is value with the peace of mind in knowing fixed expenses in retirement would be covered by a combination of social security and annuities. While I would argue this is expensive peace-of-mind, for some folks it’s worth it. So I don’t dogmatically eliminate annuities from consideration but it’s not my main focus.
Mortality Credits help with “returns”: When you and thousands of other people contract with an insurance company, the insurance is betting some of you are going to die early – and they are statically correct. This calculated bet, allows for the insurance company to afford higher payouts than just passing through the earnings on their investments of your dollars.
Some low-cost options available: Not all annuities are high-fee and high-commission. There are low-cost options from Vanguard and other providers. If a client is dead-set on an annuity, this low-cost providers are first on my shopping list.
Unfortunately, I still hear ugly stories of these products being pushed heavily on people, especially older people who may not know better. For example, I recently heard of an 80 year old signing a contract and handing over a large sum of money in exchange for “guaranteed payments for life”. In addition, this particular contract had a 7 year surrender period. Who do you think is going to win that bet and how much did the salesman pocket?
Bottom Line: Overall, I’m usually not a fan of annuities in many cases but then again, I’m not compensated by having people buy them. For select & limited situations it can make sense but like most financial products, annuities are usually “sold not bought”. Of course those that are compensated to sell annuities will have a different opinion but I’ll go back to an old phrase that I think applies to those who think annuities are always the best tools for retirement planning- “When all you own is a hammer in your toolbox, every problem looks like a nail.”