My Comments: Every year, many BILLIONs of dollars flow from the pockets of Americans into a financial contract called an “annuity”. Originally, the idea was to give an insurance company some of your money, and they would agree to send it back to you, with interest, over time.
Over the years, the sophistication of these contracts has grown exponentially and they come in more flavors than seems possible. The latest have features that appeal to many of us who are increasingly older, fully understand the temporary nature of life, and are unwilling to simply curl up in a ball and hope for the best.
They are not always cheap, ie the internal costs can be serious, but we both know that most good things in life are not cheap. But you have to either know how to evaluate what you are paying for or find someone you trust to help you. The fact that so much money is flowing into them suggests there is are rational reasons to use them. (I’ve edited this slightly since it was written for advisors and not the general public.)
Jan 21, 2015 | By Chris Bartolotta
It’s no secret that there are a lot of misconceptions out there about annuity products. You make it clear that you’ve got some preconceived (and often incorrect) assumptions when you ask the following questions.
1. Aren’t fixed annuities bad for clients?
Let’s get this one out of the way first. Even setting aside the fact that there are numerous different types of annuities, and hundreds of products of each type, there is no such thing as a category of financial products that is inherently “bad.”
That’s not to say that annuities are right for everyone; that would be equally absurd. As with most things in life, the answer lies somewhere in between. What is good or bad for a client depends heavily upon their individual circumstances. The ideal client for a fixed annuity is typically at or near retirement age, has $100k or more in liquid assets, and has a low risk tolerance. Even within that subset of the population, though, there are myriad options available. Should they look at a SPIA? A DIA? An indexed annuity? Should they buy an income rider or not?
Saying that all annuities are bad is like saying all cars are bad. If you have a one-mile commute to work and don’t travel much, you probably shouldn’t be driving an SUV. If you’re a contractor who regularly hauls heavy equipment on the job, a coupe isn’t going to work well for you. The same principle holds true for annuities, or any other financial tool.
2. What’s the interest rate on this SPIA?
Somewhere, an actuary is reading this section header and laughing. Asking about the interest rate on a SPIA points to a fundamental misunderstanding of what a SPIA is and what it’s supposed to do, which makes it all the more unnerving to the annuity-savvy advisor that this question gets asked all the time.
A SPIA, shorthand for Single Premium Immediate Annuity, is what most people think of when they hear the word “annuity.” If you need to explain it in one sentence, it’s an exchange of a lump sum of cash for a stream of payments over a certain period of time, typically the client’s lifetime.
Since an insurance carrier doesn’t know the exact day you’re going to die, it would be extremely difficult — not to mention downright irresponsible — for them to try to price it for maximum earnings over the agreed-upon time period. It’s true that a carrier will sometimes try to be consistently the best in a certain client sweet spot — females aged 64 to 69, for example — but if you’re using SPIAs to try to earn tons of money, you’re not using them correctly. They should be used to cover known, fixed expenses. Accumulation of interest is best left to a deferred annuity or to investments.
3. How can I get a hybrid annuity?
The answer to this one is very easy. You can’t.
The term “hybrid” often gets thrown around by websites purporting to be about consumer advocacy, which typically tout market upside without any downside risk. While this technically does describe certain aspects of a fixed-indexed annuity, these are not “hybrid” products in any sense of the word. They are a well-defined class of annuities that are distinguished by certain features, just like any other product.
The theory these sources will claim is that, because the product is tied to a market index but protects against loss, you have a combination of the best parts of a fixed and a variable product. The reality is that while it’s true that a market index is used to determine gains in a given year, at no point is your money actually being invested into the stocks (or commodities, in some cases) in that index. They also often paint a rosy picture where the client can catch all of the booms in the market without suffering any of the busts. In reality, because it is still a fixed product, it can do better than a traditional fixed rate, but single-digit interest is still going to be the norm. This actually leads nicely into the next question you should immediately eliminate from your annuity lexicon …
4. How much should I invest in a fixed annuity?
Another easy answer here. Nothing.
That isn’t to say your clients shouldn’t buy annuities. It’s likely that some of them absolutely should. The issue here lies with thinking of fixed annuities as an investment, when in fact they are an insurance product. After all, you need a life license to sell them, not a securities license.
When your clients think of their fixed annuity as an investment, this creates the probability that they will begin comparing it to an actual investment, in which case the interest earned will start to look poor in a hurry. It behooves you to remind them that they are purchasing this product for guarantees, not to get rich. To put it another way, explain to them that fixed annuities are the mirror image of life insurance. Their life policy insures against the financial consequences of an early death; their annuity insures against the financial consequences of a long life.
5. Aren’t annuities expensive?
No trick question this time. The answer to this one is: It depends.
Annuities are often decried as being a poor choice due to the high fees involved. A base fixed annuity contract with no riders included, however, will have no fees at all.
Now, it’s true that a fixed annuity can have fees. Most indexed annuities and a handful of traditional fixed contracts have the option to add an income rider, and the vast majority of those carry an annual fee. It’s usually slightly under one percent, though some are more expensive, and some less or even free. Other types of riders, such as an enhanced death benefit option, may also be available and carry their own fees. It’s up to the agent or advisor to ensure the consumer knows what they are so they can decide if they’re worth the cost.