I Don't Understand Annuities

Annuities violate my prime directive, “Never buy anything you don’t understand.” Annuities are complex insurance vehicles filled with conditions and clauses that are not placed there by the company for your benefit. This subject is so complex it is really beyond the scope of a blog article. However, I have received enough questions on this topic that I feel I should at least warn my readers to be very very careful when exploring these products.

Annuities come in two basic flavors fixed and variable. Fixed annuities can be considered a Certificate of Deposit (CD) wrapped in an insurance product. Variable annuities can be considered a choice of mutual funds wrapped in an insurance product. There are so many variations and options in different kinds of insurance coverage, investment choices, and riders for anything and everything it is almost impossible to get any useful information without requesting a specific proposal from a salesman. I tried to get some basic information without providing my age, my wife’s age, state of residence, etc. etc. I was informed that the information they use to make their calculations was proprietary, but I was able to pry at least this little rule of thumb out of the sales representative. If a man dies before he is 85 to company wins. If he dies after 85 he can consider himself the winner. I am not sure I believe it is that simple.

Annuities are typically sold to frightened old people with the guarantee of lifetime income. Any time a salesman is selling fear or greed. Run Away!

The biggest problem with annuities is the cost when compared to benefits. The sales commissions on these products seem to typical run around 6%-7% of the entire principal. However, they can run as high as 14%! It is very difficult to determine how much you are actually paying as these charges can be hidden by various methods.

Annuities are almost irrevocable contracts. Once you sign off on an annuity consider that money lost and gone forever. Some annuity contracts allow for withdrawal with prohibitive surrender charges that run about 7% of the account value after one year. Although they can run as high as 20%! If granny suddenly needs that money for long term care she is out of luck. Again, it is difficult to make any definitive statements about annuities. Options that allow for penalty free withdrawal after 7 to 11 years are available. Also some policies allow penalty free withdrawals of up to 10% of the principal per year for medical emergencies.

Variable annuities complicate matters even further as they have high management fees. The annual insurance fee will run around 1.25%, annual investment fees 0.5%-2.0% a year, additional insurance riders typically add another 0.6%. The total annual fees after that 6% sales commission could easily add up to 3.0% a year. Compare that to no sales charge and an annual management fee of less than 0.5% for index funds.

The guarantee provided by the typical annuity comes at a very steep price.

I attempted to locate some information on the cheapest simplest annuity possible from Vanguard, a company with an enviable reputation for lost cost high quality financial products. The deferred fixed annuity is just about as simple as it gets. Deferred means you don’t collect any money until some time in the future. The interest collects tax deferred, but will be treated as regular income at withdrawal. It comes with a 2% sales charge that is calculated into the quoted rate of return. As far as I could determine there are no additional charges. In Maryland the four year guarantee rate of return on this product is 1.25%. That means that nearly two years will pass before you break even. I asked the sales representative why I shouldn’t just buy a CD guaranteed by the Federal Deposit Insurance Corporation and save the 2.0% sales commission. She didn’t have an answer.

Like any other financial option, no investment is always going to be a bad idea. It all depends on the price that you pay for the product you receive. Many years ago when inflation was running wild my parents bought some annuities. Today they are both in their nineties, still receiving a guaranteed lifetime income sold to them when interest rates were at historic highs. I have no doubt the insurance company that sold those annuities to my parents is hating life. Given today’s artificially low interest rates driven by the Federal Reserve Bank and the future risk of inflation, I just can’t understand why I would want to substitute an annuity for low cost short and intermediate term bond funds that essentially serve the same purpose.

Then there are options for “annuitizing” tax deferred retirement accounts into a guaranteed lifetime income stream. This is an entirely different subject.

As I said in the opening paragraph, I don’t claim to understand annuities. Each individual contract is a unique product. If any of you wish to add to my understanding with specific quantitative examples, I really welcome your comments. Just sell me the steak not the sizzle.