Annuities are often touted by salespeople as low risk investments. Many investors do not understand the basic operation and risks of a annuities.
In case you’re not familiar with this investment product, let’s define what an annuity is. Basically, it is a contract between you and an insurance company. You give them money, either in a lump sum upfront or with ongoing payments. In return, they agree to pay you monthly income starting at an agreed-upon time, usually for the rest of your life.
Depending upon the specific type of annuity you choose, you may also participate partially in market returns. But if there’s a stock market drop, it doesn’t impact you….you will still receive your guaranteed payment.
At a basic level, the appeal of annuities is easy to understand. Forgo the wild swings of the stock market for a guaranteed monthly payment. That part makes sense since it is easier to secure your financial future if you can avoid stock market drops. But as life teaches us, there’s no such thing as a free lunch. To get someone to guarantee you future income as long as you live, it needs to be worth their while. And who is on the other side of these annuity contracts? Insurance companies.
Here’s an example of how it works. Let’s say the stock market goes up 11% in a particular year. Your annuity payment may allow you to receive a portion of that up to a limit (such as 3%). But if the market drops 11% instead, your payments will stay the same. That, of course, is the appeal of these investment instruments.
Because these are all contracts, there is an immense variety of annuity types and options.
In many cases, if you die before you’ve received all of your money back, the insurance company typically keeps the rest. There are options to allow a family member to receive the remainder of the income if you die. But to take advantage of that feature, you’ll likely need to pay an extra fee.
Do You Feel Lucky Today?
Do you know how Warren Buffett made most of his fortune? Through the insurance business, which is usually highly profitable. When an insurance company agrees to pay you a fixed amount for the remainder of your life, no matter how long you live, they make sure the odds are on their side.
So as an annuity investor, the deck is stacked against you from the start. You will pay for the security of avoiding investment downside.
You’ll see this reality play out in annuity contracts. These can be complex and hard to understand, so it’s difficult to look out for your financial interests. On the other hand, the insurance company has entire teams of lawyers protecting their interests.
The Very High Costs of Annuities
These insurance companies are not in the business of making losing investments. So, unfortunately, that equates to a high cost for annuity buyers. But just how high are we talking?
While this varies, these are the general types of fees you can expect:
- Mortality expenses, which are often charged as an additional fee to compensate the insurance company for its ongoing risk
- An investment expense ratio, which is charged in certain annuities to compensate the insurance company for managing investments on your behalf
- A flurry of additional fees including transfer charges, distribution, contract, underwriting, and redemption fees
Then, according to annuity.org, most annuity contracts carry general, somewhat undefined fees that are often listed as administrative fees.
All in, expect annual costs ranging from 2.46% to nearly 6% per year.
Fees are everything to you as an investor, as these costs take a direct bite out of your returns. And what if you need the money sooner or just want to get out of an annuity? Count on an extremely steep fee to extract yourself from the arrangement. Surrender fees usually start around 7% and drop gradually over time.
Add in the Commissions
Every financial product comes with a disclaimer that the investment involves risk. But one risk that the disclaimers don’t address is different: the risk that your “financial advisor” might be recommending a product simply because it pays them an extraordinarily high commission.
Conflicts of interest don’t get that much attention in the media, so not everyone knows how common they are. But research suggests these are a risk you should be aware of. In fact, a 2015 government task force report estimated this “conflicted advice” costs American investors over $17 billion every year.
Conflicted advice is found in many areas of the financial world, but one common one is annuities. One big reason is the commission’s size, which often pays the financial advisor 7% or more of the contract cost.
So, for example, if you buy a $200,000 annuity, that means a salesperson may be paid $14,000 upfront for making the sale.
Sadly, that may be a temptation many less than ethical financial advisors cannot pass up. So many investors may be sold these products, even though it is not in their best interests.
Apparently, it is Worth the Risk to Insurance Companies
In the financial world, there are two types of advisors. One is a fiduciary, who is legally required to put your interests first. The second type of advisor isn’t held to such a high ethical standard. Instead of having to put your interests first, they are required to recommend investments that are “suitable” for your needs.
This murky difference explains how that $17 billion per year of extra costs due to conflicted advice comes about.
But sometimes, in their desire to sell more of these lucrative annuity contracts, financial firms and their advisors even cross that line.
In 2016, the largest life insurer at the time, MetLife Inc., agreed to pay $25 million to settle a claim for abuses tied to annuities. This was the highest penalty in history for these products according to FINRA, the US regulator.
MetLife was ordered to pay a $20 million fine and return another $5 million to impacted customers. While the company neither admitted nor denied wrongdoing, Brad Bennett, FINRA’s chief of enforcement, made this statement:
“Variable annuities are complex and expensive products that are routinely pitched to vulnerable investors as a key component of their retirement planning.”
There’s an old industry adage that “annuities are sold, not bought.”
While Mr. Bennet used the word “pitched” instead, this is a powerful message to investors regarding annuities: let the buyer beware.
Protection at What Cost?
Yes, investing in stocks can be scary at times. But history shows that bear markets are short in comparison to bull markets.
But those selling annuities probably don’t show you that data from history.
They are also unlikely to tell you about other more cost-effective ways to protect your money, such as using option or diversification strategies.
Yes, you will still have investment risk, but you don’t have the guaranteed perpetual fee drain of an annuity.
Tips to Buy Annuities without Getting Burned
That is not to say that annuities are not ever a reasonable investment. There are times they can be a useful financial planning tool.
But I think you can see you need to buy them very, very carefully.
In general, look for more straightforward annuities with lower fees—those do exist but may not be marketed as aggressively.
Then, consider consulting a fee-only financial advisor before signing anything. These individuals don’t accept commissions and are required to act as a fiduciary for you, so they must give you objective advice. So they should be able to tell you if the annuity is right for you or give you other options if there is a more cost-effective way to accomplish your goals.