There is a certain legal document that is often frequently overlooked. Most people are ignorant…
Annuity Advertising; Misleading at Best
During the past five years the #1 question I am hearing from clients and prospective clients relates to an annuity commercial most of us have seen or heard. The annuity promises a bonus up-front of 6-8% on your initial investment and a yearly guaranteed rate of return of 7%. If when you hear this promise, which is unlike any safe investment currently available, you are not completely skeptical, then you may be willing to fund an insurance agent’s retirement. While many annuities can represent excellent opportunities, this highly publicized and seemingly generous offer is not one of them. Here is the rest of the story.
An annuity is a savings vehicle offered by an insurance company. The annuity we are referencing offers a bonus up-front when you invest. Even though insurance companies have a great deal of latitude as to what they can do and say, the first question you should ask is where is the money coming from to pay that bonus? The answer begins with understanding that you will incur a large penalty (or surrender fee) if the annuity is surrendered in the first 6-15 years. And while the amount of the penalty and the time that one is required to hold the annuity varies by policy, the surrender fee will always recoup the bonus if the policy is surrendered early. The insurance company has designed the annuity so that they have time to make enough money on your investment to be able to afford this bonus.
The insurance company can make money on the annuity in two possible ways. The first is in yearly fees which can range from a low of 2% per year to a high of 4% per year. Assume that in this annuity, the insurance company is charging fees of 3% per year; the surrender charge is 10% during the first six years, reducing to zero after the tenth year; and the upfront bonus you receive is 6%- all common assumptions. After 10 years, at 3% per year, the insurance company will have collected 30% in fees. Therefore, you will have paid yourself the upfront bonus, deducted from the money you invested with the insurance company. The second way the insurance company can make money on the annuity is by generating a higher rate of return on your investment than they are paying you.
In this scenario, even though the guaranteed 7% per year seems too good to be true, it’s important to understand that the 7% guarantee is not a rate of return; rather it is a guarantee on a theoretical account called an accumulation account which merely determines how to calculate the withdrawal amount you are guaranteed when you turn 62 or older. To illustrate, in the assumed annuity above, your money is invested in a stock and/or bond mutual fund portfolio. The actual rate of return you make is going to be the return on these mutual fund investments minus the 3% in fees. If your stock and bond portfolio goes up 7% you get a net 4% return. However, if the portfolio goes down 2%, your net return is minus 5%. Your money in this annuity is doing the same thing as if you invested in a low cost mutual fund. You are paying all the extra fees for this guaranteed withdrawal feature which you can typically begin as early as age 62. A guaranteed withdrawal is nothing more than the insurance company assuring you that if your annuity principal value (the money you invested) is exhausted by withdrawals higher than portfolio return over time, then the insurance company will continue to make the account owners guaranteed withdraw as long as they have not violated the terms of the agreement. Due to the high cost of fees your initial investment in the annuity has a greater chance of being depleted over the duration of guaranteed withdraws.
Even so, can this kind of annuity with a withdrawal guarantee be a good thing? If you live a very long time and the markets do not perform well during your lifetime it may be, but be assured the insurance company is not taking much risk; it is merely making you feel that you have less risk. For example, take a 70 year old who deposits $100,000 and is guaranteed a withdrawal of $7,000 per year. In 15 years that person will be 85 years old and will have received $105,000 from the annuity. During that same period, many of those 70 year olds have passed away without fully collecting on their investment, while the insurance company has collected net fees of approximately $30,000. In other words, if you are still alive at 85, you have only gotten a little more than your principal back, yet the insurance company has received $45,000 in fees which were used to pay you your bonus and the sales commission to the agent, still yielding a net of $30,000 or more to the insurance company. And even if your mutual fund portfolio within the annuity makes less than expected, the insurance company still collects its fees and its actuaries have calculated how many of the annuitants will die before collecting more than they put in. One certainty is the insurance company is unlikely to lose this game.
Having said that, I do believe that a Guaranteed Withdrawal Annuity can be a good choice for individuals who have no need for additional principal withdraws and do not care about the amount of principal remaining at any time in the future or after they have passed. But even under those conditions, consider a no commission annuity policy through well known companies such as Charles Schwab, TD Ameritrade, Vanguard or Fidelity. Using a no commission outlet may encourage the company representatives to help you better understand the product and minimize sales pressure.
Never forget the principle “there is no such thing as a free lunch”; when something appears to be too good to be true, trust your instincts. And if you’d like a second opinion, do what hundreds of others have done and ask an objective person, such as a fee-only advisor like the Financial Consulate.