Over the past twenty years, I have noticed that the national financial media has had a true love - hate relationship with annuities. At times, the prevailing theme seems to be that all annuities are expensive boondoggles designed only to benefit the insurance companies and agents who represent them. At other times, however, many financial authors seem to feel that they should be an integral part of any well-thought-out retirement plan. What gives? Both opinions can’t be right, can they?
In a recent white paper, I dubbed the current state of annuities as the good, the bad, and the ugly. Let’s start with the bad. Bad refers to a quality of character, and in this instance, the relatively high commissions paid by these products can induce some unscrupulous salespeople to act very badly indeed by pushing annuities without regard to clients’ needs.
Listening to recent sales pitches, one might conclude that annuity companies are giving away free money (bonuses), guaranteeing eye popping rates of return, and providing access to the stock market with no risk of loss. Unfortunately, when viewed under an objective lens, these promises fall quite short.
Bonus products provide an up-front monetary incentive (some up to 8 percent credit to your account) to invest in the offering. But what is often only explained in the finest of print is the fact that those same offerings also pay less interest than other non-bonus annuities. Add this to the reality that bonus products also come with large withdrawal penalties, and it becomes clear that most investors will end up no better off, and possibly worse, than had they forgone the so-called bonus.
Another closely related farce involves those promises of guaranteed returns that seem too good to be true, and mostly they are just that. One recent radio ad promised a 7 percent guaranteed growth of your income. Such promises will always be followed by the caveat: of your income. This qualifier keeps the sales pitch barely legal. While most who hear the ad assume that this 7 percent is a guaranteed rate of return on the amount invested in the annuity, it is in fact worth far less than that.
Here is a common example of how this “guarantee” works. An index annuity gives the investor the gains of a stock index (such as the S&P 500) but caps the growth at 3 percent a year, meaning that you can do no better than that. Therefore, a $100,000 investment can grow to no more than $103,000 in a 12 month period. Meanwhile, the account also allows the investor to take out 5 percent a year, or $5,000, as an annual withdrawal amount guaranteed for life (that’s the good part).If the investor skips this allowable withdrawal in the first year, then he can take 5.35 percent (or 7 percent more than the $5,000) for life beginning in the second year.
While this figure does represent a 7 percent increase in guaranteed withdrawal amount, it has nothing to with the actual account value. Since the actual account value can be no more than $103,000 in year two (per the cap), the withdrawal will immediately begin to erode the original investment. While not technically illegal, the 7 percent promise is nevertheless deceptive – an action that CFP® professionals are ethically bound to avoid.
So, is there any merit to annuities?
Annuities can provide income which can’t be outlived. Therefore, as part of a comprehensive and well considered plan they may be quite appropriate. I always council that annuities are ugly, laden with difficult terminology, hidden fees and expenses, and way too often sold deceptively. However, if an investor needs a guaranteed income that will last a lifetime, they may prove a good fit.
I use the term needs very carefully since this can be viewed from an emotional or situational vantage. While everyone likes the idea of guaranteed income, it is not always an investment need. For instance, some corporate or Federal pensions are quite generous and in some cases exceed the spending habits of a retiree. In this case, additional guaranteed income from an annuity might not prove very beneficial, especially when the underlying costs are taken into account.
There are, of course, many other situations in which annuities may or may not be a good fit. In fact, I’ve found that in fewer than 25 percent of the cases that I deal with, annuities turn out to be appropriate. But ultimately, nothing replaces the value of a comprehensive financial plan in helping investors to determine if the costs and benefits of annuities are appropriate for their unique situation.