Buying an annuity is not that different from buying a home. Let’s break it down:
- Both involve pretty high fees (6% realtor commissions don’t pay themselves)
- Both involve long time commitments as annuities have high surrender fees, and most homes aren’t bought to be flipped
- Annuities and a new home can involve a big money commitment
However, there is one major difference; most people do much more research before buying a home. Before buying a home you will get it appraised, have an inspector come out, check out the schools and measure the basement height to make sure that you can swing a golf club (well maybe that’s just me). Annuities are completely different. A financial advisor describes a bunch of jargon you probably don’t understand and hands you a 200 page prospectus that you never open. Or, if you do, you realize quickly that none of it makes sense. You sign some paperwork, and voila, you are a proud owner of something you may not need, don’t understand, and can’t get out of. This article will help you ask better questions of your financial advisor to compare and buy the best annuity for you.
Immediate or deferred annuity?
There are really two types of annuities; immediate or deferred. Immediate annuities start producing income immediately and deferred annuities, well you probably guessed it. For example, let’s say that you purchase an immediate annuity for $100,000. You may start receiving $5,000 per year starting immediately for the rest of your life. A deferred annuity may be bought for $100,000 and you may get a little more income, $6,000 per year. However, your income won’t start for 5 or 10 years.
I’ll ruin a little of the suspense here. You will almost always purchase a deferred annuity. This isn’t necessarily because deferred annuities are better. It’s because annuity salespeople get bigger commissions by selling a deferred annuity rather than an immediate annuity. Deferred annuities are also much more complex.
What is my surrender fee period?
Or, maybe the better question is, “When the h!$% can I get out of this thing?!” Basically every deferred annuity has a surrender period in which, if you want to get out of the annuity, you have to pay a fee. I have seen surrender periods last as long as 14 years! That’s right, you need to hold certain annuities for a decade and a half or you will have to pay a fee. Many times the fees will start over 10% and will go down the longer you hold the investment. Also, typically you can withdraw 10% of your investment annually without any fees.
Try to stick to under a 5-year surrender period and 5% surrender charge when considering annuities. If someone is trying to sell you an annuity with over a 10-year surrender period or a double digit surrender fee, run as fast as you can out of there.
Fixed index, equity index, variable or fixed annuity?
There are a bunch of different types of annuities. Here is a quick rundown below.
Fixed index or equity index
Fixed index (a.k.a equity index) annuities have all of the upside of the stock market, with none of the risk! Ok, that’s a lie, but many times this is how they are sold. Fixed index annuities are tied to the performance of an index, like the S&P 500 index. The annuity can go up in value, typically capped at a certain number, or percentage of the index return. Also, the investor is protected and can’t lose money. Sound too good to be true? That is because it probably will never return what you expect.
Variable annuities
Variable annuities usually have two parts; an investment part that can go up and down in value, and an income part that is guaranteed. In my experience, these are also the ones that confuse people the most. Many times variable annuities are sold with a certain guarantee, but the guarantee is not what most people expect. For example, I hear people tell me that their annuity guarantees a 7% rate of return. They expect that the value of their annuity will go up 7% per year. Instead, the income, if annuitized increased by 7% per year, but the actual account value can go up and down and even lose value. Yes, variable annuities can lose money. Your annuity salesman will probably never tell you that.
Fixed annuities
These should not be mixed with fixed index annuities, although the annuity companies do their best to confuse you. Fixed annuities have a guaranteed, usually low, annual rate of return. These are the most basic, but also the least popular. I guess they are too easy to understand and brokers can’t charge enough fees. For example, you may earn a guaranteed 3% rate of return, or 4% income raise, until you annuitize the investment.
What is my minimum guaranteed yearly income at age 62, 65 and 70?
Now it’s time to make the annuity salesman do some work. Although annuities take many shapes and forms, they all have one consistency. You are able to annuitize your investment and draw a yearly amount of income each year. Depending on the annuity, this calculation can be tricky. You may have no intention of actually annuitizing the money and collecting a yearly stream of income. However, you should know your options and the bare minimum you can collect, no matter what the market is doing.
What are the annual fees?
Want to watch your salesperson start to shake in his boots? Ask the total annual fees of an annuity. First, variable annuities have extremely high fees. These fees typically will exceed 3% annually. Fixed index, equity index, and fixed annuities don’t necessarily have fees. Well, none that you can see. The issue with these annuities is they are not regulated as tough as variable annuities, therefore a prospectus is not required. No prospectus means that there are no fee reporting. However, trust me, there are plenty of high fees.
If your advisor answers this question with the awful., “There are no fees!” You need to find a new advisor. All annuities have fees. Variable annuities are clearly printed in the prospectus and are very high. Equity index and fixed index annuities are a little more difficult to calculate. These “fees” come in the order of caps and participation rates on the index that the annuity tracks. Even worse, many times these types of annuities don’t include compound interest, and the index never includes dividends. These are the reasons these annuities always sound better than they really are.
Conclusion
Annuities are complicated. I hear it all the time, “All the upside of the market, no downside, no fees!” Well, if it’s too good to be true… I’m not saying that an annuity isn’t for you, but it is important that you do your research before purchasing an annuity. It is a complicated product with high fees and long-term contracts. You wouldn’t buy a home without an appraisal. Don’t buy an annuity without a financial inspection first.
Need Additional Help?
Bryan Haggard CFP®, CFA is a Michigan based fee-only financial planner. He specializes in working with families to help them live a stress-free retirement. Interested in putting together a plan to help you meet your retirement goals? Schedule a time to meet below.