Are Annuities Bad for Consumers?
Q: Are annuities bad for consumers?
A: Like many things in the world of investing, it’s almost impossible to make a broad generalization about a specific investment and then claim that the generalization will apply to everyone. That’s the downside of any generalization, whether it’s regarding a type of investment or something else. Even if the generalization is true in most cases, there could still be outliers, or situations that show the contrary.
Therefore, my response to the question is “No, all annuities are not bad.” With that said, let’s talk about things that are bad and how they could apply to the purchase of an annuity.
1. High Fees Are Bad
This is one of those generalizations that is true in every case I can think of. It’s straightforward. If you can lower your costs, you’ll get a better deal, and your investment is more likely to perform better.
How should you determine if fees are high? One thing that isn’t completely fair is to compare the costs of an annuity to the cost of a mutual fund or other alternatives, because the comparison is not equal. An annuity might provide benefits that the mutual fund account does not provide. To fairly identify if the fees for a specific annuity are high, you need to compare to a similar annuity, with similar benefits.
If you find a similar annuity product with significantly lower fees compared to an annuity that you own, that’s bad.
2. Not Understanding Your Annuity is Bad
Based on what I’ve read and heard, consumers often run into problems with their annuities because they didn’t fully understand how the annuities worked when they purchased the annuity. A good rule of thumb for consumers is to avoid anything that you don’t understand or can’t explain. You don’t have to become an expert, but you should be able to recite the basics. It’s also the job of the financial professional to help you with that, but we’ll talk more about that below.
One of the biggest things that cause annuity complaints is the lack of liquidity that comes with a typical annuity surrender schedule. In other words, early withdrawals could trigger surrender charge penalties of upwards of 10% in some annuity contracts I’ve seen.
Another big issue with annuities is the lack of understanding about how they can grow and how the benefits work. This is commonly seen with indexed annuities, where growth is often limited by an index cap or participation rate. If you own an annuity with these types of provisions, you should know what these terms mean.
If you are unaware of how the provisions in your annuity work, or if your financial advisor has not explained them to you, that is bad.
3. Buying Things You Don’t Need is Bad
Of course, we all aspire to get to the place of financial independence, where we can make purchase things we don’t need, or the “extras” guilt-free.
But, what about annuity “extras?”
Something that adds to the complexity of annuities, and hence the lack of understanding about annuities, are the riders that are often attached. These are optional add-ons that could come in the form of extra income benefits, death benefits, etc. They also come with a cost, but that doesn’t necessarily make them bad. If lifetime income is important to you, then a lifetime income rider could be a terrific addition for your annuity.
However, if income is not a concern, but you have an income rider that costs 1% per year, that’s bad. If you’re not concerned about leaving an inheritance to your heirs, but you have a death benefit rider that costs 1% per year, that is bad.
It’s imperative that you only add rider benefits that you need or want. Doing so will help lower costs and maximize your outcome.
4. Being Misled is Bad
Unfortunately, the distributors of some annuities are not held to a fiduciary standard. That is because annuities are insurance products sold by insurance agents. For those insurance agents who are not held to a fiduciary standard, their only incentive is to sell as much of their approved products as possible, to receive the maximum possible commissions.
I often hear radio commercials and television shows promoting certain annuity products, but these advertisements don’t share the entire picture. Indexed annuity advertisements, for example, usually include a claim that you can “Participate in the gains of the S&P 500 with zero downside risk.”
In most indexed annuity contracts, this is true. The growth options typically include some form of index option that is tied to the performance of an index like the S&P 500. However, they don’t mention that gains are limited by caps and participation rates, and that by participating in the annuity, you’ll have to give up full liquidity for 6, 8, or even 10 years. I would guess that many purchasers of annuities don’t fully understand these things up front, which leads to their dissatisfaction with these products.
It goes without saying that if there is an advisor making this misleading and incomplete claims, that is bad.
Does this mean that all annuities or indexed annuities are bad? Absolutely not. All annuities are contracts. If you find an annuity contract with provisions that suit your needs, for costs that are relatively low and fair, and you fully understand the limitations that come along with the contract, I think annuities can be a good financial tool.
All investments come with a tradeoff. If someone is presenting an investment to you that sounds too good to be true, it is. Run in the other direction.
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