OPINION: When Annuities Are Inappropriate
Good Morning Relaxing Retirement Member,
In an effort to bring some clarity to the many questions I receive concerning annuities last week, I outlined a few examples where annuities might potentially be appropriate for you.
As promised, here are some examples of situations where I believe the use of an annuity is inappropriate.
A classic example of a situation I see way too often that I don’t recommend is investing in a variable annuity inside your IRA or Roth IRA.
One of the many benefits of an annuity is tax deferred growth of your money. However, all investments held inside of an IRA or Roth IRA grow tax deferred already.
Given this, why would you need to place a tax deferred vehicle (annuity) inside of a tax deferred vehicle (your IRA)? An example of this is rolling over balances from your retirement plan at work, i.e. your 401(k), 403(b), or your pension plan into an IRA and investing in an annuity inside your IRA.
There really is no valid reason to do so. Although sellers of annuities tout all the bells and whistles of complicated annuities (like the “guaranteed” interest the couple who was referred to us would receive only to later discover that the insurance company charges were greater than the interest they paid).
Unfortunately, one of the main reasons why it’s recommended so often is the commission paid on an annuity vs. a traditional mutual fund. Annuities typically pay much higher commissions, so there’s a significant incentive for a broker to sell an annuity instead of just a mutual fund.
All things being equal, this alone would not be a profound problem. However, in order to pay those higher commissions, the insurance company sponsoring the variable annuity must charge you higher fees!
For this reason, I do not recommend this practice.
During volatile financial markets, products are created and heavily marketed which appear to be “one-size-fits-all” solutions.
In my opinion, equity indexed annuities fall into this category. Their promise is to allow you to invest in the stock market (using one or more indexes, like the S&P 500), yet not lose any money personally if the market index goes down.
When you first hear the concept, it sounds extremely attractive. In short, you get all the benefits of the stock market without the downside risk.
However, as with most financial instruments, you have to read the fine print.
Insurance companies do place a floor on your deposit so that when you withdraw funds from the equity indexed annuity, you will receive no less than you deposited.
However, a few key points to note:
- If you withdraw funds over the first 10 to 25 years, you have to pay a stiff surrender charge for access to your money. And, I’ve seen that charge be as high as 15%.
- Your upside potential is limited. If the S&P 500, or whatever index your annuity is tied to, earns 10%, you don’t get credited with a 10% gain on your equity indexed annuity. Your gains are capped at a much lower percentage and the insurance company keeps the rest.
Without knowing any more, if you objectively stand back and examine this product, you have to ask yourself how the insurance company can take on this exposure and not have a problem down the road.
In 2008, for example, when the S&P 500 Index dropped over 37%, how did their company stand up when they had to guarantee no losses to their equity indexed annuity customers? How are they going to keep that promise indefinitely if the stock market doesn’t cooperate?
For this reason alone, I’m not a fan of equity indexed annuities.
To sum up, as I outlined last week, I do believe there are very limited situations which warrant using an annuity as long as you do so with your eyes wide open. I simply believe that those situations are much, much more narrow than those currently being sold today.
Once you’ve digested these last few editions of The Retirement Coach Strategy of the Week dissecting annuities, and your interest is peaked, here are just a few more recommendations for you before purchasing one:
- Access to Your Money: Be very clear on the language of the insurance company’s surrender charges when you need access to your money. This is critical. There are companies who have no surrender charges when accessing your money.
- Insurance Company Ratings: With fixed annuities specifically, be careful to examine the independent ratings of any insurance company you’re considering. Remember, how well you do is directly tied to the performance of that insurance company.
- Fees: Specific to variable annuities, be very clear what their insurance charges are to run the annuity, typically 1.50% or so. If a variable annuity is what you’re after, a few companies now have very low cost variable annuities.
I hope this has been helpful for you.
Committed To Your Relaxing Retirement,
The Retirement Coach
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