Annuities can be some of the most polarizing products in the investment world. As retirement investments, some in the industry swear by them, while some say they are a complicated, overly expensive way to invest. Let’s take a look at five popular reasons why people hate these products, and also some reasons people love them.
Hard to Understand
The annuity would probably never top a list of the most easy-to-understand investment products. For starters, there are several different types of annuity products: fixed, indexed, and variable. There is a disparate set of guarantees and risks for each type, which must be fully understood in order to make an informed decision. The work isn’t done once the product type is selected, either; indexed annuity purchase payments must be allocated among a choice of several interest crediting strategies, and variable products have a menu of mutual fund-like sub-accounts to choose from. Selecting an annuity and optimizing the endless options on your own can be a complex task.
Fees are High
It’s no secret that annuity fees are some of the highest among all investment products, and variable products are the worst offenders. Mortality and expense risk and administration charges for these products can be well above 1% annually. That doesn’t include fees for optional benefits such as withdrawal benefits and enhanced death benefits. The fund companies who manage the subaccounts in which your premium is invested charge a fee, too; this is usually around 1%. Put all of those together, you could easily be looking at 3% in annual fees. That can do some serious damage to your returns. Typically fixed annuities and fixed index annuities have lower fees than variable. A comparable fixed index annuity can be found for a fee of 1% or less per year.
Lack of Liquidity
Like some mutual funds, most annuities have a contingent deferred sales charge, sometimes called a surrender schedule. For the first few years of the contract, any money that you withdraw over a specified “free amount” (usually 10% of the contract value) will be assessed a charge. This charge is expressed as a percentage of the withdrawal amount, and it decreases each year. This means that it could be several years – up to ten in some cases – before your money is available free and clear. This lack of liquidity makes a lot of people nervous about signing an annuity contract.
Annuity commissions are notorious for being some of the highest in the industry. Many industry observers have speculated that this influences advisors to recommend these products when they may not be suitable. Aside from potential conflicts of interest, there is another factor to consider: some annuity products have what is called a front-end load, which means that a portion of the purchase payment is retained as a sales charge instead of being invested.
If the load is 5%, for example, only $95,000 of a $100,000 purchase payment would be invested. That would mean your first $5,000 in gains would go toward breaking even. Over the last few years, commissions have been coming down. Regulations have attempted to reduce commissions and insurance companies have come under scrutiny as the high commissions have led to unsuitable sales practices in some cases. These days, it is common to find an annuity that will pay a 6% commission in most cases, which is more in line with other industry sales such as real estate.
The U.S. Securities and Exchange Commission requires delivery of a document called a prospectus with every variable annuity sale. The prospectus outlines all details of the annuity in language that isn’t exactly consumer-friendly. The prospectus must be presented to clients in its entirety; regulations prevent advisors from highlighting portions of the prospectus or directing clients to only read certain sections. Understandably, being tasked with interpreting such a daunting document is a turn-off for some investors. Fixed and fixed index annuities are not offered with a prospectus however as they are not a securities product.
In light of these criticisms, why do annuity sales remain strong? Annuity guarantees and benefits are truly unique. Let’s take a look at some of the most common reasons people love them.
At the core of any annuity is the ability to design a stream of lifetime income, which is an unrivaled feature in the investment world. Lifetime income can be combined with guaranteed income for a certain period of time, too. For example, a person could select lifetime income with 10-year period certain option, and if that person died within 10 years of the start of the income, the income would continue being paid to the beneficiary until the end of the 10-year period. Another popular option is lifetime income which will pay income for life regardless of how you live. This income could even be passed along to a spouse.
Virtually all annuity products have some kind of death benefit. Enhanced death benefits, typically available at an additional cost, are common in variable products. These benefits lock in benefit amounts at certain “high-water marks”, guaranteeing a certain amount to the beneficiary in the event of the owner’s death – even if the contract value has declined due to poor market performance. This may be a good option for someone whose objective is to leave money to a beneficiary but can’t qualify for life insurance as there is no medical underwriting needed for an annuity.
Annuity contracts can have designated beneficiaries, so the insurance company will pay the death benefit directly to the contract owner’s designated heir in the event of the owner’s death. This process allows the beneficiary to avoid the time, cost, and publicity of the probate process, resulting in an easy transfer of assets.
Annuity earnings accrue on a tax-deferred basis, which means that gains are not taxed until they are withdrawn. Not having to withdraw money to pay taxes on gains every year means your investment will compound at a faster rate. Aside from an IRA, there are no other investment products that offer this valuable benefit.
Participate in the market with downside protection
An indexed annuity can allow you to participate in the growth of the stock market while being protected from market declines. As the name implies, the performance of an indexed annuity is based, in part, on the performance of an equity index such as the S&P 500. The amount of interest earned is equal to the index’s gain, up to a specified maximum known as a rate cap. In exchange for being limited in the interest, you can be credited, your contract value will not decrease in the event that the index experiences a decline.
As with any investment, annuities have pros and cons, and they are certainly not suitable for everyone. To learn more about annuity products and other retirement investments, schedule an appointment with an advisor to get the most out of your retirement.