If you’ve been keeping an eye on the market lately, you know that volatility has continued. The uncertainty has created a perfect opportunity for salespeople to come knocking with an answer to the fear of losing money.
Fixed annuities can be very attractive to investors. They’re simple and pay 3% at most. That kind of annuity is a financial product designed to accept and grow the principal, and then provide scheduled payments to the individual for the rest of the person’s life. Fixed annuities are designed to deliver reliable income without the risk of outliving your money. But this is not the type of annuity Kathy is referring to.
I received this email from Kathy last week:
“I’ve been hearing about variable annuities that go up with the stock market, and when stock market drops it doesn’t. It just stays the same. I think they’re called “indexed annuities.” If this is the case why doesn’t everyone have these? There has to be a catch. Can you explain so I can understand? Why are they pushing these so much? What do the sales people get for selling them?”
Luckily, Kathy is wise enough to know that when something sounds too good to be true, it probably is. Yet salespeople are very skilled at making a complex product sound very simple. In reality, these products are written with complexityto disguise the truth. Here’s an example: A salesperson calls you offering an annuity that provides a “guaranteed retirement income” of 5% a year. “It’s simple,” he says. “You invest $100K, and it’s guaranteed to grow at 4 or 5%.” But what the annuity really provides isn’t nearly so simple.
If the market tanks 25% and you cash in the annuity, you would receive only $75K of your $100K. That’s not much of a guarantee. On the flip side, if you agree to accept “income” for the rest of your life, you’ll be allowed to withdraw up to 5% a year on the full “value” of your account, which is now $127,628. That means your original $100K investment will provide 5% a year in income, or $6,381 ($531.75 a month). At that rate, it will take about 16 years to recoup just your principal amount of $100,000. Assuming you took out the annuity at age 60, by the time you’re 76 you will basically break even. You may have avoided some market risk, but considering that the market grows at an average rate of 6-7%, someone is making money off your investment—and it certainly isn’t you.
But the annuity “guarantees” 5% growth, right? Here’s where the complexity (and the lack of clarity when speaking to most salespeople) comes in. Most annuities with guarantees are talking not about “cash guarantees” but “income guarantees.” And while you and I may assume “income” means what we’ve earned on an investment, in this case it refers only to what you can withdraw, or your “retirement income” before they die. In many cases, investors won’t even withdraw the full value of their principal investment. What’s that mean? You may as well have put the $100K under your mattress—NOT a strategy I recommend!!
Here are some other downsides of variable annuities:
- Annuities lack flexibility. My clients want access to what they need when they need it. If you need to withdraw more than 5% from an annuity, you jeopardize the “guarantee” and pay other surrender penalties. In other words, you’re stuck at 5%, regardless of your needs.
- You will pay more for spousal benefits. Withan IRA or other traditional investment account, your beneficiary receives the remaining funds after you’re gone. If you want your spouse to receive benefits from your annuity, you’ll probably have to take a discount on the withdrawal amount while you’re living. Otherwise, the insurance company would have to absorb the increased cost of insuring two life expectancies.
- The devil is in the details. As with any investment, excess fees can limit growth and cut returns down the line. These include annual fees and administrative charges, surrender penalties, the scope of the downside risk, and more. As I told Kathy, “If it sounds too good to be true …”
So why are salespeople so anxious to sell you an annuity? It’s not your retirement they’re thinking about—it’s theirs. (For more on this hot topic, see my blog, For your nest egg, “free” advice can be costly.) Sales people usually get a 6-8% commission up front on the amount you put in. So while there’s a big incentive for them to make a sale, there simply is no such thing as a guaranteed 5% annual return annuity. (Any company that offered such a product would be out of business before you could collect on the promise!) If you’re not 100% certain you understand a product—including what exactly is guaranteed and what you can realistically expect as a return on your investment—get answers to your questions from an objective third party before buying.
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