Have you ever wondered if you should purchase an annuity? Has a financial salesmen ever tried to sell you one? Annuities are a form of insurance that protects the owner (you) from outliving their money. In their simplest form, you give an insurance company a lump sum of money and the insurance company sends you a monthly check for the rest of your life. Note I said simplest, because annuities come in MANY shapes and sizes. Annuities are products that, when used responsibly, can possibly help you achieve your financial goals... the devil however is in the details. Here are some things to consider before purchasing an annuity:
Who’s “recommending” the annuity?
It is important to understand the bias of the person recommending that you purchase (or not purchase) an annuity. People that sell annuities are paid on commission, and therefore only get paid when you purchase something from them. Just like anyone that gets paid on commission, this puts the salesman in the position of being biased towards you buying the product.
Annuity salesman are not required to sell you the best product for you; they can instead attempt to sell you the best product for them. For instance, if they could sell you an annuity with a 4% guaranteed rate of return and they get a 5% commission, or an annuity with a 3% rate of return and they get a 10% commission, they can sell the 3% product and don’t even have to tell you about the 4% one. Why? Because legally they are held to a “Suitability Standard” which means the product they sell must be suitable for your situation, not necessarily the best one for you.
If you ask a financial planner if you should purchase an annuity, and they are also your investment advisor, then their answer may be tainted as well. Although legally required to make the recommendation in your best interest, many fee-only advisors only get paid on the assets they manage. If you take $1 million out of your portfolio to buy an annuity, then they may be losing out on a substantial amount of fees.
It is always important to be aware of the potential bias your salesman or advisor has.
Buying in your IRA
Clients frequently have been sold annuities using money in their IRA. This is a HUGE red flag. If someone is trying to sell you an annuity in your IRA, you should probably walk away and consult another advisor.
One of the primary benefits of many annuities is they provide tax-deferred growth, meaning you don’t have to pay taxes on the growth each year. Growth in an IRA is already tax-deferred, which means you are not benefiting from the tax deferral of your annuity. This is like going into your home when it rains, and opening an umbrella to be twice as dry. It makes no logical sense. And yet most of the annuities that my clients have been sold are held in their IRA’s. Annuities typically get sold in IRA’s because that’s where the client has their retirement savings.
Know the fees
Depending on the bells and whistles the annuity comes with, you could have a lot of different types of fees. These may include mortality and expense fees, management fees, surrender penalties, administrative fees, and more. Every added bonus (also called rider), such as guaranteed minimum returns or return of premiums, will have a separate fee. I actually saw an annuity give a 2% guaranteed return (in additional the minimum 3%) and charged 2% for the guarantee. The client thought they were getting 5%, when in reality it was still the same 3%. This is an extreme example, but not unheard of.
Finally, if you are buying a variable annuity, the mutual funds held within the annuity have separate management fees. The management fees are typically different (usually higher) than the fees for the same fund not held in an annuity. Expect overall fees to run in excess of 2%.
Typical recommendation
For the instances when it makes sense for a client to purchase an annuity, a fixed immediate annuity is typically my recommendation. That being said, everyone’s situation is very different so this is certainly not a recommendation for you! Consult with a financial planner that is a fiduciary to find out if an annuity makes sense for you, such as members of NAPFA or the Garrett Planning Network.
Full disclosure, I am a member of both organizations. I recommend them for the same reason I am a member, and it is because I believe they are the best sources of advisors that are required to do in their clients best interest.
Although Suzy Orman may disagree, I do not believe annuities are bad. I have in fact recommended them to some clients in order to help meet their financial goals. Unfortunately, I frequently see annuities misused so you need to be careful before jumping into one. Fortunately, you have 30 days in Wisconsin to change your mind so if you purchased an annuity but aren’t sure you should have, you can always cancel the contract.
So what do you think? Has anyone ever tried to sell you an annuity? Are you wondering if buying an annuity makes sense for you? Let me know in the comments section.
Alan Moore is a fee-only financial planner and founder of Serenity Financial Consulting in Shorewood WI. Follow him on Twitter @R_Alan_Moore. You can contact him at alan@serenityfc.com, 414-455-5313, or visit his website at www.SerenityFC.com. Want more education? Download your free guide to the “10 Easy Steps To Securing Your Financial Future Today.”
One point that I thought I would add to your article is that fixed annuities have an inherent interest rate which is a basis for the value of the annuity. That interest rate very often mirrors current market yields (think of a hybrid of 10 year treasury bonds and 10 year investable corporate bonds). So the price of the annuity may fluctuate inversely to the market yield. Considering the historically low current market yields, if you can defer fixed annuity purchases to a period of high market yields, you may save some money.