As life expectancy increases and stock market volatility seems to grow, annuities are gaining in popularity as people seek safety for their money. Last year, fixed annuities saw $139.8 billion in sales, which is an all-time high, according to InvestmentNews.
It is essential to share some truths about annuities and explain the risks of these seemingly safe products which are sold as “can’t miss” solutions.
What Is an Annuity?
According to Investopedia, "an annuity is a financial product that pays out a fixed stream of payments to an individual, and these financial products are primarily used as an income stream for retirees. Annuities are created and sold by financial institutions, which accept and invest funds from individuals. Upon annuitization, the holding institution will issue a stream of payments at a later point in time."
In other words, when you purchase an income annuity, you give up access to your money (liquidity) to an insurance company to collect a "guaranteed" monthly check. The insurance company then invests your capital into the markets and earns the long-term benefit of being an investor, while you earn a small annual yield. Not to mention, you have now placed your assets into one company that is “guaranteeing” the income payments, and they are not FDIC insured.
At Carnegie, we feel annuities are tremendously oversold. These products are not the Swiss army knife solution they are sold as.
Here are our top reasons we don’t recommend annuities, in most cases:
1. Annuities generally have high commissions.
When you buy an annuity, you will pay a high commission to that nice salesperson. For fixed income annuities the commission can be 3-4% of assets, and on a variable annuity it can be 6-10% of the assets invested. If you want to know why annuities are oversold, high commissions are the reason. Insurance companies hide the commission very well, despite the requirement to sign a contract. Usually the “surrender period” is tethered to the sales commission, so if you have an 8-year surrender period, meaning you have eight years of penalties before withdrawing all your money without a penalty, the commission you paid may be 8%. Think about this, if you invest $100,000 in an annuity and pay an 8% commission, you are paying $8,000 for the two-hour meeting with that salesperson. The salesperson is guaranteed to make money, you are not.
2. Variable annuities often have high annual costs in addition to the commission.
Just like many financial products, variable annuities come with high annual costs, typically 2-3% per year. Every perk added onto the basic annuity adds more annual costs. If you want a death benefit, it is an additional fee, if you want a guaranteed income rider, another annual fee. With annuities, the costs of commissions and fees can be tough to discern. The commission goes to the salesperson and the annual fee goes to the insurance company.
3. Annuities are sold by people who may have a high level of conflict of interest.
The insurance company representative who sells you the product is making a commission on that sale. He or she has no fiduciary responsibility to look out for your best interest. If it feels like the representative is only sharing the bells and whistles of an annuity and not the downsides, that is probably true. In contrast, an RIA or fee-only fiduciary has a responsibility to act in your best interest. In the example above where the commission was $8,000 on a $100,000 annuity sale, it would take Carnegie eight years at our annual fee rate of 1% to earn what the broker made in one day.
4. Annuities may reduce your liquidity.
Buying an annuity is essentially giving up control of your money to an insurance company. If you annuitize it, you will receive a lifetime income stream, but the funds are now the property of the insurance company. Some annuities give you the ability to pull out 10% of your funds per year without a penalty, which means they get to charge fees on 90% of your money until the 6- to 10-year redemption penalty is over. This lack of liquidity can be an expensive risk in the future.
5. This could be the wrong time to lock up funds in fixed annuities and guarantee a low return.
When you buy a fixed annuity, you are locking in a low fixed rate of return for the long term. Locking up money at the low end of the interest rate cycle (such as a 3-4% rate of return) forever, may be using the wrong tool at the wrong time. We all know it makes sense to refinance our homes when interest rates drop, but it usually doesn’t make sense to lock in a low investment return.
6. Annuities are not "guaranteed" by the US government.
The "guarantees" provided in annuities are not the same as an FDIC-backed guarantee or a government backing. Annuity “guarantees” are provided by an insurance company. Although the insurance company may be a big and seemingly stable company, bad things can happen. For example, AIG was the largest insurance company in the U.S. before the last recession and then collapsed due to the company’s losses in credit default swaps.
7. With an annuity, to get all the guarantees, you have to die or annuitize.
With annuities, you never get the full benefit from the guarantees unless you annuitize the product or die. If you die, your beneficiaries will receive at least the amount you invested, which is nice, but does nothing for you. If you annuitize the product, it means the insurance company keeps your money, and they will pay you a stream of income for life. Again, your funds are no longer yours. If you choose the income stream to continue to your spouse after you die, another annual fee is assessed, which will reduce the annual income paid during your lifetime. At the core, you are working with an insurance company who understands life expectancies.
8. Annuities bought in an IRA are usually redundant.
One of the best benefits of an annuity is that it is tax-deferred. The ability to put large sums of money into an investment and the growth be free of taxes until sold is the single best perk of an annuity. Taking IRA dollars that are already tax-deferred and buying an annuity is a very expensive IRA investment.
What are alternatives to annuities?
Annuities are long-term investments and force people to hold them for many years. Long term, you may be better off investing the money you would spend on an annuity in the stock market. This may allow you to profit from the market growth instead of the insurance company. It's also a good idea to sock away money into tax-deferred IRAs whenever you can. While insurance companies promote the “guarantees” of an annuity, this benefit can be overshadowed by the other risks mentioned above.
In our experience, annuities are often imperfect tools to financial challenges that require more thoughtful solutions within the context of your financial plan.
Are there some cases where annuities make sense?
While annuities are a sub-optimal tool in many instances, they can serve an important and valuable role depending on the situation. For example, many long-term care insurance coverages are structured as a type of variable annuity and that is OK. For another example, consider a single or widowed person in their 70s with a health concern such as Parkinsons, with around $500,000 in savings. For a person in that situation, maybe living alone, an annuity may make sense, as this person may be at a high risk of running out of funds. This takes the risk of the market off the table and ensures at least some income continues for the remainder of his or her life.
If you are considering investing in annuities, please contact us, and we can provide alternative ideas and guidance.
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The opinions and recommendations expressed herein are those of Carnegie Investment Counsel. The material was prepared by or obtained from sources which we believe to be reliable, but accuracy is not guaranteed. Any opinions expressed herein are subject to change without notice and are not intended as a recommendation to purchase or sell a security. Past performance is no guarantee of future results. Investment advisory services are offered by Carnegie Investment Counsel, an SEC registered investment adviser. Registration as an investment adviser does not imply a certain level of skill or training. Carnegie does not provide legal, insurance, or tax services. For a detailed discussion of Carnegie Investment Counsel and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov
