Annuities, particularly certain types, can play a legitimate role in creating retirement income. But given the potential conflicts of interest outlined in Senator Elizabeth Warren’s recent report on dubious annuity sales tactics, it’s also clear that investors considering an annuity need to take care to assure they’re buying an investment that benefits them as much as the person selling it. Here are three questions that can help you determine whether you’re getting an investment you really need at a reasonable price.
1. How does this annuity work and what, exactly, will it do for me? Annuities come in many varieties, so it’s important you understand what benefit the annuity you’re considering is designed to provide and how it provides it. Immediate annuities and longevity annuities are relatively straightforward. You hand over a lump sum to an insurer in return for the insurer’s promise to pay you guaranteed monthly payments for life that start at once (immediate annuity) or at some point in the future (longevity annuity). The insurer provides this benefit by pooling your investment with that of other investors and distributing payments from that pool over time. Even should the money run out, however, the insurer is on the hook for the guaranteed payments. If the insurer can’t meet its obligations, a state insurance guaranty association serves as a backstop.
Other annuities are more complicated. Variable annuities, for example, can also provide guaranteed lifetime income, but they often do so with something called a GLWB, or guaranteed lifetime withdraw benefit rider. The initial payment you receive with this arrangement is typically smaller than what you would receive with an immediate annuity, but the idea is that you also get to invest in mutual fund-like “subaccounts” that can boost the size of the payment you receive over time. Whether your payment rises, however, depends on, among other things, how the subaccounts fare over time.
At the top of the complexity scale are indexed annuities (also known as equity-indexed annuities and fixed index annuities). An indexed annuity’s return is typically tied to a market benchmark like the Standard & Poor’s 500, although they also provide a minimum guaranteed return, say, 1% to 2% these days. The idea is that you have potential for stock market upside but protection against loss. Indexed annuities can also generate regular income, either through fixed payments as with an immediate annuity or payments tied to investment performance. Where things can really get complicated is that these annuities use arcane methods to calculate their gains (daily average, monthly point-to-point, annual point-to-point) and typically impose spreads, participation rates or caps that limit the share of the market’s return you receive.
I’m not saying you should automatically pass on investments that are more complex. But the more complicated an investment is, generally the harder it is to compare to other investments, the tougher it is to assess how it will perform and ultimately the harder it is to determine whether it’s appropriate for you. Simpler is usually better.
2. What are the downsides? To determine whether any investment is right for you, you’ve got to know not just its pros, but its cons. And that’s especially true of annuities, where the downsides can be significant.
With immediate and longevity annuities, the major downside is that if you die shortly after payments begin (or even before they begin in the case of longevity annuities), you’ll have invested some of your retirement savings and received little, or even nothing, in return. That’s why you would usually want to devote only a portion of your assets to these types of annuities, leaving plenty of other savings for assets such as stock and bond funds that can provide liquidity and long-term capital growth.
With other annuities the cons may not be so apparent. For example, an indexed annuity with its upside potential and loss protection and may seem like all gain and no pain. But because of the limits features like participation rates and caps place on returns, the value of your annuity may grow much more slowly over the long run than had you simply put some of your money in cash and/or short-term bond funds for security and the rest in low-cost stock index funds. The same goes for variable annuities with payment riders that are supposed to provide a growing income stream, except that it’s the insurance and investment costs that may limit growth rather than caps and participation rates.
Before you buy any annuity, you should insist that the salesperson or adviser show you not just the rosy outcomes, but demonstrate in detail the worst-case scenarios as well.
3. What costs and fees will I pay? Things can get tricky here because most annuities don’t break out operating fees and expenses. The exception is variable annuities, where a litany of fees (the mortality and expenses charge, annual investment fees and the cost of riders and options) that can total upwards of 3% annually are disclosed in the prospectus. But you shouldn’t have to wade through a 300-page prospectus to find them. Ask the salesperson to list each separately in writing and total them up.
Other annuities also have costs, but as with CDs and savings accounts, they’re not explicitly disclosed. In the case of immediate annuities and longevity annuities, you can get a sense of whether one annuity’s costs are higher than another’s by comparing the size of the monthly lifetime payments each makes for a given investment (although you’ll also want to consider an insurer’s financial strength rating rather than just pick the one with the highest payout).
There’s one other charge that can be helpful in assessing fees and expenses: the surrender charge. With the exception of immediate and longevity annuities, most annuities levy a penalty for early withdrawals known as the surrender charge. These surrender charges typically start at 7% to 8% and decline gradually until they disappear after eight or so years (although many annuities allow you to withdraw up to 10% of your investment each year penalty free). Some indexed annuities, however, have surrender charges that can start as high as 20% and take more than 15 years to expire. Generally, the higher the surrender charges and the longer they run, the more of your investment is being eaten up by fees and expenses.
Another important cost, sales commissions, also typically aren’t disclosed, but that doesn’t mean you shouldn’t ask how much the salesperson will earn if you buy an annuity. If nothing else, you might be able to get a sense of whether a difference in commissions may be a factor in why a salesperson is recommending an annuity instead of another product, one type of annuity vs. another or even one company’s annuity rather than a competitor’s. I’d also ask whether the salesperson stands to receive any of the kinds of non-cash compensation—trips, golf outings, tickets to sports events, etc.—described in the Warren report.
If the salesperson balks at providing such information—or gives you a line that suggests none of your money goes toward commissions or marketing expenses—I’d move on to someone willing to be more upfront where your investment dollars are going.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org. You can tweet Walter at @RealDealRetire.
More From RealDealRetirement.com