The financial services industry has done a poor job with making things simple and easy to understand for the majority of the public. There are 50-page mortgage documents, 100-page fund prospectuses, and we currently have an unnecessary and onerous debate in Washington on a widespread fiduciary standard (it should be as simple as the client comes first!). While investments of all types will have some sort of sophistication, there is one type of investment vehicle that seems egregiously complex. Annuities tend to sound like a win-win, no-brainer investment for anyone listening to a salesperson’s pitch. However, when one digs under the hood (i.e. reads the 40 page prospectus of certain complex annuities) they can spot higher costs, a loss of liquidity and portability, and usually a hefty commission for the salesperson. Now, certain annuities (specifically single premium immediate annuities or SPIAs) may fit into a diversified asset allocation strategy and reduce the risk of you outliving your money. However, in today’s low-rate environment one must consider the risk of locking into a low interest rate as rates will eventually rise over the next 10 years.
There has been a flood of index, variable, and deferred annuities that have hit the market in the last 20 years. From 2000 to 2009 index annuity sales increased from $5.3 billion to $29.9 billion. A common sales tactic for index annuities is selling on the fear of a market downturn. Humans are wired to prefer avoiding losses twice as much as they would enjoy receiving a gain. This loss aversion is used against many prospective annuity buyers by salespeople with the pitch of never experiencing a market loss in any one year. Some of these products come with flashy pitches that promote no negative returns while being able to participate in market upside. The devil is usually in the details with these annuities as many of the index annuities have caps that limit the upside that you could receive if the market goes up. Other strategies may offer ‘bonuses’ of 10%, but many of those are not worth as much as they seem and occasionally people never collect them. The fees in these strategies usually outweigh the potential benefits that would be provided.
David Blanchett, the head of retirement research at Morningstar, explains the risk of outliving your money in the video below. As Mr. Blanchett reiterates in the video, costs on certain variable annuities can run north of 4% a year! One area that Mr. Blanchett did not dive into is the lack of liquidity in many annuities. There are annuities being sold today in which you cannot cash out before 10 years unless you want to incur a large surrender fee (some as high as 20%). These surrender fees can be burdensome for a retiree that experiences an unforeseen medical expense and needs to access their money immediately.
Here are a few things to consider when someone is recommending you to purchase an annuity:
1) Make sure you find out what all of the costs are associated with this product. Many times certain fees will be tucked into the lengthy prospectus report and not disclosed up front.
2) Will I potentially need to draw from these assets in the next few years? If this is a possibility, then you must understand the rules and potential surrender fees in accessing your money.
3) How much does the person selling me this product stand to benefit? We recommend asking this question and the response that you receive can be quite telling of their true motivation.human sphere
Please make sure that you ask plenty of questions if you are ever considering an annuity. A strategy that appears to be a no-brainer is rarely as simple as the salesperson may have you believe. Remember, there is ALWAYS going to be a risk tradeoff in investing (whether it’s losing control of your money, purchasing power, or outliving your resources). Don’t be fooled into thinking you have found a strategy without risk. Dive into the details, ask tough questions, and do not be afraid to walk away if you don’t receive the answers that you’re looking for.