Learn why this is an excellent time for would-be annuity owners and repeat annuity owners to seriously consider purchasing an annuity.
A single, 60-year-old California man recently invested $100,000 in a plain vanilla fixed annuity that paid a handsome annual rate of 5.1% over five years. Even after relentless increases in interest rates in 2022, that was an attractive deal. But it was still beatable.
So, with the help of a signed free-look period and an attuned annuity broker, he backed off his initial purchase and bought a different fixed annuity that paid 5.6% annually – half a percentage point more. This meant that after five years, including compounded interest, he would pocket $131,316 instead of $128,237 – a difference of more than $3,000. Along the way, his monthly payouts would be $615, or $50 more than the original annuity paid.
The bigger payout wasn’t all that huge, but it turned out to be an advantage for this person because he is not particularly affluent. “This sort of thing means a lot for some people,” says one annuity financial advisor.
The benefit of a free-look period
The advisor was attentive to rising annuity payouts, common today. But even more important was the free-look period, which enables an annuity buyer to cancel the contract within 10 to 30 days for no reason and no penalty. This is not the case for a stock, a mutual fund or even a bank CD. It’s designed to give annuity customers a way to protect themselves from the complexity of some annuities and predatory sales practices. (It’s usually sent to you, but you have so sign it and return it.)
Unfortunately, many annuity owners, particularly seniors, don’t fully understand what they have bought. In fact, some investors have lost money in recent years as a result of unethical sales practices. These actions may involve a broker or financial advisor misrepresenting or omitting important facts about an annuity, making false claims about a product, or recommending an unsuitable product in order to earn a commission.
The good news is that states began regulating annuity sales in 2003. Today, nearly half of states have implemented or plan to implement the National Association of Insurance Commissioners’ Best Interest Rule, which requires agents to act in their clients’ best interests. But there is also bad news: More than half of states still don’t have this rule, which is why unethical sales practices remain common across the country.
Beware variable annuities
Prospective annuity buyers should be particularly wary of variable annuities, which charge substantially higher fees than other annuities, and, in some cases, deferred income annuities, which usually have higher surrender charges and aren’t suitable for folks over 75. They may not live long enough to reap the benefit, but are sometimes sold to them anyway.
Prospective buyers should also be cognizant of the value of so-called bonuses, which are commonly not as good as they seem. In some cases, the bonus, fundamentally just a sales tool, is worth less than any increased charges you may pay for the bonus. In addition, prospective buyers can often get a better deal on a competing annuity offering no bonuses.
Annuity owners should also be wary of tax-free 1035 exchanges, a component of the tax code that allows an exchange of an existing variable annuity contract and some other types of annuities without paying any tax on the income and/or investment gains on your annuity contract. The new annuity, for example, may have a larger death benefit or, in the case of a variable annuity, a wider selection of investment choices.
On the downside, you may be required to pay surrender charges on the old annuity. In addition, a new surrender charge period generally begins when you exchange into the new annuity.
Changing one variable annuity for another may backfire
Here is an example of how exchanging one variable annuity for another may be a mistake. Say, for instance, you hold a variable annuity with an account value of $72,000 — one no longer subject to surrender charges — and exchange it for a new variable annuity that is very similar, except that it pays an 8% bonus credit. Your account value in the new annuity is nearly $78,000. It has a surrender charge period of eight years, beginning at 9% in the first year.
If you subsequently decide that you have to withdraw the entire value of the account because of an unexpected emergency, you have wound up making a bad financial move. Assuming that your account value hasn’t increased or decreased because of investment performance, your account is now worth only $71,000, less than you had sitting in your old account.
To sidestep these and other issues, the best solution is to educate yourself as thoroughly as possible about annuities and to make point of asking your financial advisor lots of questions before making an annuity purchase.
Here are some tips:
- Make an effort to determine which type of annuity is best for you. There are multiple types of annuities. Some emphasize guaranteed payouts, such as a multi-year guaranteed annuity (MYGA); some do the same thing but also offer additional upshot potential, such as a fixed indexed annuity; some invest solely in the stock market, such as a variable annuity; and some also invest in the market but offer some downside protection, such as a structured annuity. The preferred choice for an individual varies widely.
- Determine how your annuity choice fits in with other income. View an annuity in the context of all your retirement income and savings, and determine what purpose each income stream will serve. At a minimum, you probably receive Social Security payments, and that may be enough, for instance, to satisfy your need for lifetime guaranteed income. If you’re concerned about outliving your savings, however, you might want to purchase a fixed income annuity with guaranteed lifetime income.
- Check the credit rating of the insurance company offering the annuity. Consumers have little other objective information to determine the likelihood that they will in fact receive their promised benefit in the future. Rating company AM Best is the gold standard. All AM Best A ratings are excellent and can be as high as A++. Retrieve your ratings from a reliable source, not necessarily your broker.
- Learn how much the contract will cost annually, including all expenses. Fees vary, based on the type of annuity and the insurance company provider. At the high end, variable annuities typically charge roughly 3% annually. At the low end, growth-oriented fixed indexed annuities may seemingly charge nothing. (Fees are imbedded, but at least a financial advisor can tell you accurately what your payout may be, depending on financial market performance.) One way or another, fees are higher than mutual funds, albeit mutual funds offer no guarantees.
- Be mindful of surrender periods. These are annual charges, relatively steep, if you exit the annuity before the end of the contract. Many annuities, however, allow annual penalty-free withdrawals ranging from 5-15%.
- Annuities aren’t automatically adjusted for inflation. They often can be for an additional fee. In the past, these often didn’t make sense financially, but this is changing now that inflation has become a big problem. Also, if you stick with an annuity for a decade or more, paying for at least some inflation protection is likely a good idea if you can afford it.