Fewer than 10% of Americans own annuities. Ever wonder why, given that they offer distinct benefits, including higher interest rates than available elsewhere and guaranteed income for life?
The answer is that annuities can be complicated and are often hurt by misconceptions. Before you consider buying one, you have to do homework. And then you have to make sure you avoid mistakes that can lead to making a bad financial decision.
Want to avoid the traps? Here are 10 key tips:
Do not convert too much of your savings into an annuity. While annuities deserve a spot in many portfolios, they are fundamentally illiquid. So if someone in your family suffers a financial setback and needs help, for instance, you might not be in a position to support them. Never put more than 50% of your financial assets into an annuity, and most people should top out at less – probably no more than 40%.
Pay attention to costs, fees and related parameters. Annuity costs vary, depending on who you buy them from and, more important, the terms of the insurance company selling the annuity. Among the variables are broker commissions, surrender fees, subaccount fees in variable annuities and so-called participation rates, spreads and caps in fixed indexed annuities. Ask lots of questions, comparison-shop and review the expense page of the prospectus if one is available.
In particular, pay attention to lengthy surrender fees. These are stiff fees to pay if you bow out of an annuity early. They are not unreasonable; an insurance company makes a long-term commitment in selling an annuity, and it wants you to do the same. Nonetheless, surrender fees are problematic if life throws you a curve ball.
The surrender penalty in the first year is typically equal to the number of years in the entire surrender period. So if the surrender period is 12 years, the first year penalty is usually 12%. It drops slowly thereafter, when you are most likely to into a problem. The only way around this is sound financial planning. Do not overinvest in an annuity/annuities and make sure you have covered the bases regarding your liquidity needs, including possible surprises, before an annuity purchase.
If you buy something more complex than a super-simple fixed annuity – an insurance company’s version of a bank certified of deposit – make sure you understand the difference between the “account value” and the “benefit base.” The account value is the actual value of your annuity contract — i.e., real money – and typically determines what your beneficiary will receive in the event of your death. More important is the benefit base – a figure distinct from the account value and one that determines the basis of your income payments. For example, you might receive 5% of your benefit base annually, regardless of what happens to your account value.
Do your homework in choosing the right annuity. There are fixed annuities, fixed indexed annuities, immediate annuities, variable annuities and deferred annuities. Which is best for you depends on a large number of variables. One important one is when you want to start receiving payments. Another is your risk orientation – i.e., are you willing to bet on the stock market, at least in part, or do you prefer the iron-clad safety of a fixed investment? Weigh this before approaching a broker so that his/her research time is best spent.
If you opt for a fixed annuity, strongly consider building an annuity ladder because interest rates today are unusually low. Fixed annuities provide a better deal than available elsewhere, but rates will probably be higher at some point down the line. Since it’s impossible to know when this will occur, the best bet is to buy, say, three fixed annuities instead of one, with each maturing at a different point in time. This increases the odds that rates will be higher when at least one of these annuities matures, allowing you to replace that annuity with another one paying more.
If you buy a fixed indexed annuity (FIA), make sure you understand its underlying index. It’s often not as cut-and-dried as, say, an S&P 500 index fund. Some FIAs, for example, use the Morgan Stanley Dynamic Allocation Index. This is described as a rules-based quantitative strategy that uses modern portfolio theory principles and the related concept of efficient frontier to maximize returns while investing in ETFs and an index representing equities, short-term Treasuries, bonds and “alternatives.”
Know what this boils down to? Probably not. If so, ask your broker and make sure you do, and that you like the concept. If you can’t understand the index, move on to a different FIA.
Don’t ignore the impact of inflation when buying a fixed annuity. Fixed annuities are super-safe but still not risk-free – inflation can be a problem. When you buy annuity, you pay today for a guaranteed return in the future, and that means inflation always poses a risk. Many investors don’t take into account that your payments almost certainly will be worth less at payment time. Don’t be one of them. You can either calculate how much you really need and adjust that amount by likely inflation or purchase an annuity with an inflation protection component. Be careful in weighing the latter; often the protection is not worth the price.
Do not ignore the option to buy a “period certain” annuity. Some people do not buy annuities with guaranteed lifetime income because insurance companies typically get a better deal than beneficiaries upon death if they don’t live to a ripe old age. This can be avoided, however, by buying a period certainty annuity, which keep payments coming for a specific number of years. If you die beforehand, your beneficiary receives the remaining payments. Also, if you are marred, you should purchase a joint annuity, which continues payments as long as one of two spouses is living.
As you approach retirement, do not ignore annuities altogether. Annuities are not for everybody who can afford them. If you are wealthy, for example, you probably don’t need an annuity, and neither do you if you’re among the few who receive a generous pension from your former employer. For the rest of us, however, an annuity may well make sense if you are relatively healthy as you approach retirement — especially an annuity with a lifetime income rider. This is because running out of money in retirement is among the biggest concerns of most retirees. It’s also a problem that can be almost impossible to solve because you don’t know how long you will live.
A guaranteed income rider helps solve this problem. The only real alternative is prolonged exposure to the stock market — which beats returns from other financial investments — but this is really only viable if you can ride out bear markets reasonably well. These can be particularly trying in, say, your mid-70s, because you don’t know how long a bear market will last. Undergoing a bear market at that age or older, while you’re simultaneously withdrawing income from the market, is no picnic.
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