Financial products in general are often looked at through the lens of skepticism because, as with many industries, there is a history of past abuses. The “annuity” is a prime example of a product that is sold almost as often as it is misunderstood. Annuities have been touted by some, as one of the greatest of all financial vehicles. Those individuals also make a habit of selling them to each and every one of their clients. Like the saying goes, “if all you have is a hammer, then every problem looks like a nail”.
An annuity, in its simplest form, is nothing more than a contract between a client and an insurance company. The contract promises a cash payout in retirement in return for monthly or annual premium payments by the client. Some annuities pay a fixed interest rate on the account value prior to retirement while others invest the premium payments or track the S&P 500 index. Oftentimes, annuities will also offer a guaranteed income rider in retirement. This rider, which usually comes at a additional cost, guarantees that the client will receive a specific dollar amount when they enter retirement.
If all of that sounds confusing, that is because it is! Annuities, like many other financial products, can be very confusing if not properly explained. So how are you, the reader, supposed to know if an annuity is right for you? What are some things to watch out for? What if you already own an annuity and know nothing about it?
Do you need an annuity?
Let’s get this question out the way first. Most people do not need an annuity while they are working full time and in their prime earning years. As you approach retirement and are considering how much income you need, then it might be a good time to consider an annuity.
If you work hard and are diligent about investing, then there is a very good chance that you will be well prepared for retirement. However, your financial plan can be disrupted if the market takes a dip just as you are beginning to take funds our of your portfolio for retirement. One way to protect against this risk is by creating your own personal pension in the form of an annuity.
As mentioned above, an annuity offers the client an income stream in retirement and oftentimes that income stream can be guaranteed ahead of time. For example, let’s say that you invested $200,000 in a variable annuity 10 years before retirement with an income rider of 5%. Let’s also assume that the investments in the variable annuity return a modest 7% a year on average bringing your balance at the end of 10 years to just under $400,000. With an income rider of 5%, this would give the client about $1,600 a month in guaranteed retirement income.[i]
Having a guaranteed income stream from an annuity can greatly reduce the client’s need to withdraw funds from their investment portfolios when the market is down. While there are other benefits to buying annuities, this is the most common and relevant example.
Things to watch out for?
One of the most common things that I see when evaluating an annuity is the lack of obvious benefit to the client. Crazy right? Why even sell an annuity if it has no benefits or guarantees? In that case the client would be much better off investing their funds in an IRA or brokerage account. Not to mention the fact that if you wish to get out of an annuity, within the first several years of owning it, the insurance company charges a fee!
The unfortunate truth is that annuities of this nature are sold for only one person’s benefit: The salesperson. Variable annuities often pay a large up-front commission to the professional who sells it. In recent years this has become quite a problem with many cases of annuities being sold improperly. Unfortunately, the victims of many of these cases are oftentimes venerable adults and senior citizens. So how do you know if you have been sold, or are being sold, an annuity that is not in your best interests? Here are a few questions to ask your financial advisor:
- Why are we utilizing an annuity as opposed to an IRA?
- Does this annuity offer me any benefits or guarantees that I couldn’t achieve elsewhere?
- What fees will I pay for owning this product?
- What fees would I pay if I were to cancel this policy and how long do I need to own it before those fees go away?
If your advisor cannot answer these questions or you still don’t understand why you were sold the annuity, if may be time to seek a second opinion.
Annuities can be an especially useful tool for preserving your hard-earned retirement assets and providing a guaranteed income stream. However, they can also be used and abused for the personal gain of the person selling them. It’s important to understand how these products work and what questions to ask. Should you need a second opinion on your current annuity policy please reach out to me at alex.overbeek@lpl.com or (616)-208-5088. I would be happy to help!
[i] This is a hypothetical example and is not representative of any specific situation. The hypothetical rates of return used do not reflect the deduction of applicable fees and charges.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.