Annuities can be complicated. This column will not be.
After I wrote two weeks ago about getting tossed out of the office of an annuity salesman, there was a surprising clamor for more information about this room-clearing topic. One group of readers just wanted a basic explainer on how annuities work. For that, read on.
Key retirement milestones
Another group of readers worried that those hearing of my experience might assume that all annuities are bad, and that all people who sell them use subterfuge to do so. Neither of those is true: Next week, I’ll introduce you to some reasonable people who are trying to use certain annuities in new and improved ways.
Insurance, not investments
The insurance companies that create annuities often make them seem like investments. But really they’re more like insurance.
At their simplest, annuities offer a guarantee. If you turn over some money, you’ll be guaranteed to get all that money back — plus usually a certain amount more. Or you turn over some money and you’ll be guaranteed a regular check for a certain period.
Like insurance to stave off financial disaster, an annuity is something you purchase to guarantee that you won’t run out of money if you live a long time. Such financial guarantees are attractive. After all, we don’t know how our investments will perform: This year may be the first in a while that your stock and bond index funds both lose money.
Still, annuities are not a mainstream product. This is partly the fault of the annuity companies, since they have long outsourced the sales process to people who do not always have customers’ best interests at heart. Word is out about how annuities are sometimes sold, and it’s not good.
Another problem: The annuity product lineup has become so filled with complex offerings trying to solve every problem and answer any objection that the word “annuity” itself can mean lots of different things. I’ll divide them into four categories.
Paycheck annuities are the simplest annuities, and they are kind of like a pension. You hand over a pile of money, and in exchange you can receive a regular check for life.
An immediate income annuity generally starts sending checks very soon, and they keep coming until you die. What you get each month will depend in large part on how much money you hand over, your age, your sex, whether you’re including a spouse in the package (so the checks keep coming until the second person dies) and the prevailing interest rates at the time you buy the annuity.
Deferred income annuities, also known as longevity insurance, work similarly, but the checks don’t start coming right away. The longer you wait to receive payments — you buy at 65 but don’t start collecting checks until 85, for example — the bigger the checks will be.
There is risk involved with a deferred income annuity. Each year that you wait in between the purchase and the first check brings you closer to death, and the annuity company is betting on your eventual demise. The fun — broadly speaking — in annuities is beating the odds and collecting checks until you’re 105.
Fixed annuities start the same way: You hand over some money. That money grows for a predetermined period at a rate that is relatively easy to explain and understand (that’s the “fixed” part); then you can turn it into a regular check for life if you’d like.
Sometimes, the amount that the annuity company credits to your account will change once per year based on prevailing interest rates. Other times, in the case of multiyear guaranteed annuities, it works more like a certificate of deposit — you will know exactly how much money you’ll accumulate over time. These annuities tend to run longer than standard certificates of deposit.
Variable annuities exist for people who want to have their cake and eat it, too. They can offer a guaranteed check for life with a promise that they won’t lose money. But variable annuity buyers can get more money than the baseline minimum, depending on how certain mutual funds that they select perform.
The annuities I described above don’t give their owners access to the stock market. But variable annuities come with what are known as sub-accounts that can.
That access comes at a price, though. The fees here also tend to be so high that they have been the subject of many investor alerts from regulators over the years.
Equity indexed annuities
The last type of annuity is the equity indexed annuity, which is the type that the salesman I met a few weeks ago was selling at a steak dinner he held for people contemplating retirement strategies.
With an equity index annuity, you still receive a guarantee that you’ll get your money back. And if the equity index — say, the S&P 500 (.SPX) — goes up, the annuity company will credit a portion of that to your account. Not only is your gain usually just a percentage of the actual gain, the overall amount you get in any year might be subject to a cap and additional costs.
Light reading on annuities
Any decision you make about an annuity is bound to be important, given how much money the person selling it will most likely ask you for. But much of the background reading on the topic is dull and confusing.
So here are three things that I actually enjoyed reading and made me think harder. One of them, “Annuity Insights,” comes from Fisher Investments. They don’t like annuities very much over there, and make money managing other kinds of investments.
The other two come from academics I’ve spoken to who do think certain annuities are worth considering, and both have other jobs that could earn them more money if more people buy annuities.
The first, “Fixed Index Annuities: Consider the Alternative,” by a Yale professor, Roger G. Ibbotson, explains how some index annuities could help people in a rising interest rate environment. He is chairman of an investment firm that could receive compensation for licensing rights to indexes that annuity firms might use.
The second, “Annuity Fables: Some Observations From an Ivory Tower,” appeared in the Journal of Financial Planning and was written by Moshe A. Milevsky of York University in Toronto. It is more of an omnibus piece about the mean things people often say about annuities and whether they are true. Professor Milevsky has a variety of consulting engagements related to the products.
Questions you should ask
Even within the above categories, annuities can vary radically. There is almost no end to the bells and whistles and levers and switches. So I wouldn’t buy even the simplest one without reading the contract three times and hiring someone for a second opinion about whether an annuity really fits my overall financial strategy.
Then come questions, lots of them, for which you should demand answers in writing:
What happens if I suddenly need some or all of my money back? What happens with the annuity if I die? What taxes will I pay? Aren’t you going to spend hours asking me about my assets, goals, dreams and fears before you sell me something this important? And will you agree to act in my best interest — as a so-called fiduciary — and sign a pledge saying so? If not, why not?
The questions don’t end there.
What are all the circumstances under which I might not get back the money I am handing over? What part of the contract might limit or change how much money I eventually receive? What can change during the term of the contract? Is there any possibility that payments could increase with inflation? Must I take a monthly or other regular payment at any point during the term of the annuity, or is it merely an option?
Finally, can you please provide a list of all the fees I’m paying? And what are you earning in commission from this sale?
These questions are easy enough to understand. If the replies aren’t equally simple, you should walk away. Given the stakes in any annuity sale, you should feel a strong sense of entitlement to clear, direct answers.
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