Why would you buy an annuity?
Ken Fisher hates annuities. You can find him on what seems like every other CNBC commercial screaming how much he despises annuities. He calls variable annuities obtuse, confusing, and hence rarely read. The sales reps that are paid obscenely large commissions don’t even know what they are selling most of the time.
People buy variable annuities because they want stock exposure but don’t want to lose money in the stock market. They soon realize that there is no free lunch. The Financial Industry Regulatory Authority once sent out an investor alert that, the marketing efforts used by some variable annuity sellers deserve scrutiny—especially when seniors are the targeted investors. Sales pitches for these products might attempt to scare or confuse investors. One scare tactic used with seniors is to claim that a variable annuity will protect them from lawsuits or seizures of their assets. Many such claims are not based on facts, but nevertheless help land a sale.
An annuity is not an investment. It is a product designed so that someone will not outlive their savings. They give up most of the upside of the S&P 500, but gain the certainty that a check will be in their mailbox each month. The guaranteed income in a very strong selling point. When the stock market sells off and investor fear is high, annuity sales will always increase. In the midst of the 20% downturn back in November 2018, variable annuity sales went up 25% over a one year time period.
I believe that if I gave a 20 question exam on the bells and whistles of a variable annuity to a potential owner, they would fail. Most variable annuity buyers don’t understand the products. Here are a few reasons why variable annuities are not a good product solution:
- There is no step-up in basis – A nonqualified annuity does not provide a step-up in cost basis at death. All of the deferred earnings (gains) will be taxable as ordinary income to a non-spousal beneficiary.
- Beware of the penalties – The surrender schedule of 8%, 7%, 6%, 5%, 4%, 3%, 2% indicates a 7-year surrender period. These schedules are long because they lock in buyers after they realize that they made a bad decision.
- High Expenses – The mortality expense, administrative fees, fund fees, special fees, will eat away investment returns at a clip of over 2% a year.
- No tax advantage for IRA’s – Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) is a bad idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson (Source: FINRA Investor Alert).
- No inflation hedge – During the annuitization phase the payout is a fixed payment that will not hedge against rising inflation.
- Limited investments – The investments inside many variable annuities have layered fees and many of the insurance companies will limit investment options to lower risk funds.
- Horrible death benefits – Your beneficiaries could potentially lose a substantial part of your annuity if they take the full cash value (immediate payout option) upon your death. They might be forced to take your annuity over 5 years to get the full death benefit.
Even though I’m not a fan of variable annuities, there are a few types of annuities that I would recommend to clients. An immediate fixed annuity is an appropriate product to provide a paycheck for life with a guaranteed income. This annuity could be a great way to manage risk and limit exposure to market volatility. It would also improve diversification and transfer all the risk to the insurance company.
If you want to learn more about annuities, I can provide you with a second opinion to find out if it’s the right fit for your retirement plan. Like all financial decisions, every choice is unique to your own personal situation and risk tolerance.
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