Having trouble sleeping at night and counting sheep isn’t working? For most people, this is the only use they have with an annuity prospectus. And who can blame them. Have you ever looked at an annuity prospectus? You’d be better off reading a latin cookbook. Most people have no idea what the prospectus is saying and the ones that do, would never buy an annuity in the first place! I’m here to tell you how to read an annuity prospectus, or more importantly the 1% of the prospectus that you need to understand.
The Surrender Charge
Variable annuities are almost always deferred, which means that the annuity grows (or doesn’t) for a set period of time before you can annuitize it and start receiving periodic annuity payments. You will also have the option to cash the annuity out and receive the cash value but the problem is that you typically will pay a high surrender charge if you cash it out too early. The surrender fee schedule will usually look something like this:
In the example above, you will see that as the person holds the annuity longer, the lower the surrender charge. For example, if you purchased the annuity above with $100,000, it would cost you around $8,000 in year 1 to get out of the annuity. This person would have a surrender charge for the first 8 years of the contract. I have seen surrender charges for as long as 12 years! It is very important that you know what your surrender charge is before purchasing an annuity.
By the way, you will never see the commission that you pay on the purchase of the annuity in the prospectus. These commissions are extremely high and are the reason that people sell annuities in the first place. The rule of thumb though is that the annuity salesperson receives 1% commission per surrender year. In the example above which has an 8 year surrender period, you would expect that the salesperson would receive about an 8% commission on the sale of this annuity. Make you want to start selling annuities yourself?
Also, many annuities offer a bonus, which appears to sweeten the deal for buying an annuity. For example, you may get a 5% starting bonus added onto your account value. This may seem like a great deal, but usually a bonus comes with higher surrender charges and a longer surrender period. Trust me, the only person getting a bonus is the annuity salesperson.
Variable annuities have some of the highest fees out of any investment product you can own. Here is an example of how fees may be laid out for you:
|Annual Maintenance Fee||$50|
|Mortality and Expense Risk Charge||0.95%|
|Defined Income Benefit Charge||1.5%|
|Total Insurance Charge||2.6%|
The example above is from a Prudential Variable Annuity called the Prudential Defined Income Variable Annuity. Prudential is nice enough to lay out all of the insurance fees and add it up for us. In the example above, the yearly insurance fee is 2.6%. Many times the prospectus doesn’t add it up and really tries to hide this fee. If you think 2.6% annually is crazy, you’d be right but we aren’t done there. Variable annuities consist of mutual funds that have a cost as well. Again, this fee is usually hidden somewhere else in the prospectus, usually in the investment section. In the annuity above they have an average “Portfolio Operating Expense” of 0.75%.
All-in-all you would have to add the insurance charge, maintenance fee, and investment operating expenses. This Prudential Defined Income Variable Annuity charges at least 3.4% annually! This doesn’t include the surrender charge that you would also have to pay if you cashed out of your contract early. Want to know the reason that an annuity typically makes for an awful investment? Subtract 3.4% annually from any investment and you have no chance of keeping up.
Growth Rate and Income Table
This is where it starts to get complicated. It is very important to understand that variable annuities contain two parts: a cash value and an annuitized value. So far we have discussed the cash value. The cash value of the annuity is invested and if withdrawn there is typically a surrender charge. The huge fees that we already discussed, all are part of the cash value of the annuity. For most people the cash value is the important part of the annuity because it is the amount that you can withdraw at any point. Unfortunately, this is also where most people are misled. Too many times when I speak with a family that is being sold an annuity, they feel like they are getting a guaranteed rate of return. The most common misconception that a person has is that the annuity gets a guaranteed rate of return, but if the market does better, they get this higher rate of return. THIS IS A LIE. The cash value of the annuity, the important part for most people, has no guarantees. This is 100% based on the investment returns, and remember you are paying over 3% per year in fees in the annuity example above. Sorry, but no investment that has those sort of fees can be a good investment.
The “guaranteed” rate of return applies to the annuitized value, not the cash value. When you annuitize your annuity, you turn your investment into a guaranteed stream of income for the rest of your life. Almost no one does this with their annuity, therefore the guaranteed rate of return has almost no impact on your investment. Either way, you need to know what this guaranteed rate of return will be and how much income your annuity will generate if you do decide to go this route. The two things that you will need to know is the growth rate of your annuitized value and the yearly income you will receive from the annuity.
Below is the table from an Allianz Variable Annuity which explains the guaranteed growth rate and income table. These are typically published in a supplement to the prospectus because rates will vary depending on interest rates.
The Annual Increase Percentage (guaranteed rate of return) in the example is 6%. So, what does the annuity salesperson tell you? He tells you that your annuity has a guaranteed rate of return of 6% per year! Remember this is a lie, only the annuitized value grows by 6%, and this isn’t even a real number. You can never withdraw this money, just take a yearly stream of income. Oh yeah, in the example above the 6% is simple interest, it isn’t even compounded interest which makes it even worse!
The Payment Percentage Table on the right tells you how much income your annuity can generate on a yearly basis. For example, a 70 year old man would be able to withdraw 4.5% per year, but if he wants his younger wife to also get the money if he were to die early, the withdrawal rate goes down to 4% annually.
Let me give you an example giving the scenario above. A married man who is 62 and his wife is 60 and they decide to buy the Allianz annuity above. They purchase the annuity knowing that in 10 years they want to annuitize the annuity and get the yearly stream of income. Here is how it breaks down:
- The couple gives $100,000 to Allianz to purchase the annuity shown above at husband’s age 62 and wife’s age 60.
- They allow the annuity to grow for 10 years
- The annuity grows to $160,000, which is 6% per year simple interest
- The couple can’t pull out that $160,000, that is just the annuitized value (the amount that they can withdraw is based on market returns minus those huge fees that they pay)
- The couple annuitized the $160,000 which generates 4% income, or $6,400 per year
In other words, this couple gives this annuity company $100,000 in order to generate $6,400 per year for the rest of their life in 10 years. Does this sound like a good deal? If so, I have some ocean front property in Arizona to sell you. In the example above, it takes 26 years just to recoup your original investment of $100,000! This includes the 10 years that you defer your annuity before collecting income and then another 16 years of $6,400 per year of income to get your $100,000 back. If the couple dies within 26 years of taking out this annuity, they will generate a negative rate of return on this investment. And you wonder why annuity companies are so profitable and sales commissions are so high.
Variable annuities are high fee, high commission products that are extremely confusing to understand. The 80 page prospectus that the annuity salesperson provides makes it even more difficult to understand. Although almost all variable annuities are awful investments, it is important to understand what to look for when looking at variable annuities. First, you should know what the surrender period and surrender charge will look like if you were to cash out of the annuity early. Next, you should know and calculate all of the yearly fees that you will be paying on a year to year basis. Last, calculate what your stream of income will be if you do annuitize your annuity. If you want to really scare yourself, calculate how long you have to live before the annuity actually generates a positive rate of return. You want a really good use for that annuity prospectus? Tear it up, start a nice fire with it, pour a glass of wine and find a good financial advisor that won’t sell you a crummy variable annuity.