As a financial advisor for widows, I am constantly hearing about widows being preyed upon in their moment of weakness by agents aggressively trying to sell them annuities. In this article we are going to discuss the questions central to whether or not you should buy an annuity: what annuities are, what annuities are useful for and what they aren’t, and why annuities are bad and when they make sense.
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And now onto the blog!
What is an annuity?
The short answer is an annuity is like buying a private pension for yourself, backed by an insurance company.
The long answer is an annuity is a contract between an insurance company and an individual in which the individual is granted the right to a certain stream of income that will last their lifetime. The income stream may either be contractually guaranteed or it may vary in accordance with certain market-sensitive instruments. An annuity may pay out the stream income immediately or at a later point (a “deferred annuity”), and any money within it grows tax-deferred. There are many types of annuities – too many to cover within the scope of this blog. Please refer to this primer from Annuity.org for more information about the annuity spectrum.
A paint brush and a high-powered drill can both be categorized as a tool; these tools are very different and perform very distinct functions. Annuities are lumped into one category but can vary greatly in what benefits or features they offer. If you are painting a house, a paint brush would be perfect for the job, a drill not so much. Just like using the wrong tool for a project, the wrong type of annuity, can be really frustrating, expensive, and sometimes devastating when it doesn’t match your financial goals.
Reasons annuities can be labeled bad
Here are the reasons why an annuity may be a bad investment; beware of these factors before making any purchasing decision.
One of the biggest reasons that people say annuities are bad is the surrender charges, or a fee that you must pay to the insurance company if you withdraw from or cancel the annuity prior to a certain time. The term varies by contract – you should always read the contract to know for sure – but the period is usually somewhere around 5 to 10 years.
To be very clear: if you withdraw money from your annuity during the surrender period, you will pay a surrender charge, which is usually a percentage of the amount you took out. Some surrender charges are as high as 10%. This is directly deducted from the balance and reduces the value of your contract.
The main purpose of an annuity is to offer a guarantee or defined benefit. There is no such thing as a free lunch. You pay higher fees for those guarantees. Annuities fees can be between 2-4%.
Make sure you are paying for what you need. A couple bought an annuity that would pay a set income, with the option that they could start at 65 or wait. There was a large fee specifically for that income rider. At retirement the income was not needed because they had pensions and social security. They never started the income and instead paid large fees over many years for a guarantee they did not need. They could have instead paid for protection on growth or a death benefit for their children, whom they had wanted to leave an inheritance.
For some types of annuities the sales pitch may be that there are no fees. There may be no explicit fees, but the “fee” is your opportunity cost. The contract still takes these costs into account by limiting your growth through caps, spreads, participation limits, etc. On top of that, they are locking your money up for a period of time.
Another reason annuities are viewed as a bad financial product is because of commissions. Annuities can have large upfront commissions paid to the agent who sold it. There is little transparency to the purchaser on how much and when the agent is getting paid. The commission is baked into the fees you have to pay.
If you are asking yourself whether or not you should buy an annuity, remember this key point: Upfront commissions give a lot of incentives to get someone into an annuity and little incentive to continue to provide service and advice after you are locked into a contract with large surrender fees.
There are starting to be annuities sold with no commission as long as they are sold through certain Registered Investment Advisor platforms. The annuity does not have a commission as part of its payout so the returns may be higher or fees lower. Every firm does it different, but in some cases you pay the advisor whatever fee you negotiated to find and advise on an annuity instead of the insurance company paying an agent to sell their annuities.
Annuities can be very complex. The purchaser of an annuity gets a long legal contract and it is full of legalese and technical terms. It is not a flexible contract.
After college I worked at a call center in customer service for individuals who owned annuities from that company. People never knew how these contracts really worked until the very moment they needed money from the annuity. I often heard emotions of surprise or disappointment when they realized the annuity was not what they thought and it would be difficult to withdraw money or make it fit their needs. However, I also heard emotions of satisfaction when the annuity was the right fit.
An annuity is NOT a financial plan
Before you buy an annuity, know this:
The fact that annuities come with high penalties for withdrawing money should not be ignored. It’s imperative to understand that an annuity is not to be taken as a substitute for a financial plan. You should never rely on an annuity as a sole source of income, because if you need more than it can give you, you’ll have to tap the balance and pay the surrender charge.
Only put money into an annuity if you are not going to touch it until the surrender period is over. To be certain that you will not have to access it, you must have a financial plan in place that estimates what your income needs are likely to be, and what the possible sources of that income are.
Bad Annuity sales pitches – don’t fall for them!
Here are some things that insurance agents say to widows to compel them to buy annuities.
“Upside without the downside.” One of the main purposes of an annuity is to offer protection from losses in the markets. This can be useful for someone looking for security or protection for their money. Annuities can be a tool to mitigate risk, but they are a complex tool and as mentioned before must be selected to fit your specific needs as they can be a long term and sometimes permanent decision.
Market downside is not the only consideration of risks to your money. For example, a fixed income annuity product would take your money and convert it into an income stream that is a certain percentage of your principal value. This provides income but not necessarily that much upside potential. For example, you aren’t protected from inflation. If you are earning 2% on the annuity, and inflation is 8%, you are losing 6% on an inflation-adjusted basis.
Any time an agent makes such a claim like this, or maybe even something like, “Get up to an 18% return with market protection, with principal protection”, be skeptical – it could be more a play on semantics than a true statement.
To get true market upside, you’d have to buy a deferred annuity – one that usually comes as labeled “indexed” or “variable” – and this carries with it a slew of covert fees and conditions (participation rates, performance caps, etc.) that most people don’t take the time to decipher. These are not “safe” and there is downside.
It’s a good idea to consider more than just market volatility when buying an annuity. Buying an annuity just because it’s safe or adds protection to your plan is not the only consideration; but that’s how these are often sold. You should never make a decision about an annuity in a silo without considering your financial plan.
“We’ll create a free financial plan for you.”
The issue is that a free financial plan usually isn’t thorough, and it’s highly biased. The reason is so that the agent can propose an annuity as the solution at the end of the rainbow. Annuity illustrations use backtested return scenarios
If an agent shows you how well an annuity would have done for you if you had held it over a certain historical time period, be skeptical. These kinds of backtested illustrations are common when an agent is trying to sell a new product.
Hindsight is always 20/20. There no risk to you looking back at past performance, but if you were teleported back to that particular point in history when you were faced with the decision to buy it or not, you wouldn’t have the assurance that the annuity would have done as well. Those past performance numbers can be cherry-picked to find the years that make the annuity look the best.
Why annuities can be bad for widows
Check out our podcast on widows and annuities.
In the midst of your grief, it’s so easy to get sweet-talked by a smooth agent who describes a rosy scenario. They’ll even go so far as to make it their business to learn your kids’ names and where they go to school, etc. They’ll invite you to a dinner seminar and follow up gracefully.
That doesn’t mean you should still buy the annuity from them.
Here’s an example of why annuities can be bad for widows.
One young widow trusted an insurance agent to put her husband’s life insurance money into a couple different annuities. No financial planning had been done to determine what her income needs were, what the tax impact of receiving income would be, etc.
She found later that if she wanted to take the money out before 59½ there would be a 10% penalty and taxes on the growth. She was in her 30s! She had young children and had not finished her college degree. That money was to be used for her college, her children’s college, emergencies, braces and all the other expenses that come with kids. But there were penalties to access that money. She was not happy with the slow growth of the annuities, but due to the surrender fees, taxes, and penalties she was hesitant to take it out and put into anything else.
What got her into this dilemma?
Initially the proposal of market protection might have been appealing to her right after a traumatic experience like losing a spouse. Once her future plans became clearer, she wanted to see growth on this money to help accomplish her goals. The annuity is not a flexible product that could be changed as life changes.
Some widows may experience brain fog , distraction, or unclear plans and goals for the future after the loss of a spouse. This widow in the example above does not remember being told about the penalties and taxes, or details about what was discussed concerning the intended purpose of that money. It was during a time when she was in survival mode and lots of things during that time were a blur. Right after you lose your spouse is probably not the best time to be making permanent decisions like buying an annuity.
But it’s not just widows who need to think through this decision with clarity. If you are wondering if you should buy an annuity, make sure you are approaching the decision with total sobriety. Buying an annuity is a big decision and it should be approach with all the information and with total objectivity and reasoning.
Annuities are a “buyer beware” situation when you do not work with a fiduciary. If the agent is not a fiduciary then they are only held to a suitability standard. Fiduciary standard means they have to do what is in the client’s best interest, which is the highest standard of care. If the agent is following only suitability standard the annuity must be suitable, not in their best interest. This leaves a huge loophole for the buyer to be sold a less than optimal product, especially concerning products as complex and long term as an annuity.
Buying an annuity is a lasting decision. She needed a partner but got a salesperson instead, one who let his or her short-term need for a commission overshadow what the individual’s financial agenda was. It should have been the other way around – but it wasn’t.
This is unfortunately an all-too-common occurrence for widows. In a time of great financial uncertainty, they are often preyed upon by unscrupulous annuity salespeople looking to make a 10% commission.
How to avoid getting sold a bad annuity
Let’s say the prospect of buying an annuity is something that you would like to entertain. We suggest you following these guidelines to avoid getting sold a bad annuity.
- Don’t be afraid to take control of timing. Like we said, the agent is always going to want to “close the deal” as soon as possible. You are the one who dictates how fast this process goes. Don’t feel you need to make this decision according to their timeframe; and if your attempts to slow down the process are met with resistance, this may not be the right relationship for you.
- Gain a keen understanding of the annuity’s “contractual guarantees”, or other words, what must be delivered to you by the terms of the contract. All others benefits may be hypothetical and misleading.
- Get a “specimen policy” for the annuity. It is a generic form that isn’t customized to the deal the agent is trying to sell you, and for that reason will provide a more objective view.
- Remember the old adage: if it seems too good to be true, it probably is.
- Don’t put more than 30% of your wealth into an annuity.
- Before buying, create a financial plan that includes a projection of the taxes you will pay in the years you are taking income from the annuity.
- Get proposals from several insurers, not just the company the agent represents. If the agent won’t do this, get another agent.
And most importantly, trust your instincts!
Were these tips helpful?
At Rock House Financial, a fee-only financial advisor in Farmington, Utah. We work with folks from all backgrounds, and we have a financial advisor for widows as a prominent member of our team. If you are considering your retirement, wondering if you should buy an annuity or not, or just would like to speak with us, please reach out.
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