There is a lot of conversation about annuities lately, as they are heavily marketed to the growing senior population. The court seems to be out on whether they are worth it. Some people are proponents, and some are not; some are good products and serve a purpose, and some are more beneficial to the person selling the product than for the one buying it.
Following is a brief and objective discussion on what annuities are and what you should think about when considering an annuity, courtesy of Slutsky Elder Law, your prime Medicaid attorney for Chester County, PA.
What Are Annuities?
Annuities are an insurance policy, and while some can have an investment component, they are—legally speaking—insurance. Annuities provide a guarantee: if you turn over some money, you’ll be guaranteed to get all that money back, and often some return, on your principal. Alternatively, you can turn over some money and you’ll be guaranteed a regular check for a certain period (a defined period with an end or the life of the policy owner).
Similar to insurance for staving off financial disasters, an annuity is something that you purchase as a guarantee that you won’t run out of money if you live a (hopefully) long life. Such financial guarantees are attractive, as we never know how our investments will perform: there are years when the stock market returns 15-20% or more, and there are years when having a nice, safe 2% return is far better than the market return. There are plenty of years in history when the stock and bond markets lost money on massive scales.
The Complicated Side of Annuities
Often, the problem with annuities is not the product itself, but the fact that it is so complicated and that the person selling it is doing so on commission. Some annuities can have substantial commissions that incentivize selling this complex product, even when it is not the right choice and the client does not truly understand what they are buying. This is not in any way an attack on all insurance salesman—there are many honest ones who look after their clients’ interests. On the other hand, the abuses in sales of deferred annuities are well documented and need not be repeated here. Nonetheless, there are many types of annuities, they are complex and difficult to understand, and people do not always grasp what they are buying.
Different Kinds of Annuities
Paycheck annuities are the simplest annuities. You make a payment to the insurance company and receive a guaranteed check for the rest of your life. The amount is based on your life expectancy, gender, prevailing interest rates, and whether you will purchase a single life interest or have the annuity continue paying out to your spouse after you die. The insurance company takes on the risk, and for that, you get a guaranteed payment. If you have a long enough horizon and invest your funds in a diversified investment portfolio, you will likely do better. However, many people are not good investors, cash out at the wrong time, or feel they do not understand the markets, and want that guarantee.
Deferred income annuities, also called longevity insurance, work similarly, except that the checks don’t start coming right away. The longer you wait to receive payments (for example, you buy at 65, but don’t start collecting checks until 85), the bigger your checks will be. There is risk involved with a deferred income annuity, as every year that you wait in between the purchase and the first check brings you closer to death, and the annuity company is, to put it bluntly, betting on your eventual demise.
Fixed annuities start the same way. You give the insurance company money, and the money grows at an agreed rate that can change depending upon your agreement with the insurance company. You can keep the money in the annuity and let it continue to grow, take some out or convert it into an income stream like the one above where you get payments that are guaranteed.
Variable annuities have an investment component. They can offer a guaranteed check for life with the promise that they will not lose money. However, variable annuity buyers can get more money than the baseline minimum, depending on the performance of certain mutual funds that they select. These “sub-accounts” invest in mutual funds similar to ones you can purchase outside of an annuity. However, the administrative fees (for managing the funds and the mortality costs) tend to be much higher than similar mutual funds purchased outside the annuity. In other words, there is no such thing as a free lunch. If you want the downside market protection, you are going to pay for it.
With an equity indexed annuity, you’ll still receive a guarantee that you’ll get your money back. And if the equity index goes up, the annuity company will credit a portion of that to your account. You are not going to get the entire gain of the particular index; you typically get only a modest portion, but there is no downside risk of loss, either.
Some Common Issues with Annuities
One of the most significant issues with annuities is surrender charges. To justify offering the product and its guarantees, the insurance company needs to keep your money for a while. If you buy such an annuity and later wish to liquidate it in the first few years, the insurance company loses money. They recoup that by charging a surrender charge, which is a penalty based on the size of the withdrawal and is a percentage of the money. It usually declines each year, and after a certain period you can remove your money penalty-free.
Reputable companies usually have surrender charges of 5-7 years. Without making a blanket judgment, I would be wary of annuities with surrender periods beyond seven years or with surrender charges above 7%. In my experience, they rarely provide superior benefits to justify the higher costs. Also, some of the better products will have a clause that either reduces or eliminates the surrender charges if you need to go into a nursing home.
Questions to Ask Before Buying an Annuity
Consider asking yourself these questions before buying an annuity:
- What happens if I suddenly need some of my money back?
- What happens with the annuity if I pass away?
- What taxes will I pay for withdrawing the funds?
- Ask yourself: Did the salesman/advisor learn enough about me, my other assets, income, and needs? If not, this person is selling you something for the commission only. A good advisor will want the annuity to fit your needs and profile. If the advisor does not have a global picture of your financial situation, then he/she cannot make the best recommendations.
- What could change during the term of the contract?
- Is there any chance that payments could increase with inflation?
- Must I take a monthly or another kind of regular payment at any point during the term of the annuity, or is it just an option?
- Finally, can the advisor provide a list of all of the fees I’m paying? And what are they earning in commission from the sale.
If the replies aren’t understandable, or the salesman seems antsy about providing the answers, or the answers simply do not make sense as to how this product benefits you, you should walk away.