Annuities: Investment, Insurance or "Rip-off"?

Today, identifying exploitation in the financial services industry has become a professional responsibility. It is my belief that dishonesty and corruption run rampant because of the commission-based structure built into many of the products sold to senior adults. These products, and the impact they have on seniors’ investments, need to be scrutinized.

Do you remember your introduction to basic biology in junior high school? We were taught there are two basic types of life: plants and animals. The animal kingdom can be broken down in several different ways: vertebrae or non-vertebrae, warm-blooded or cold-blooded, mammals or non-mammals and so forth. In a similar manner, annuities can also be classified. All annuities fall into one of two classifications: fixed or variable. Variable annuities are investment vehicles; therefore your principal is at risk. These investments are typically mutual funds and bond funds placed within the annuity contracts. A securities license is required to sell variable annuities.

On the other side of the annuity “kingdom” are fixed annuities. Fixed annuities are not investments. They are, by definition, savings plans because your principal is not at risk. However, in the fixed annuity world there are many species. Some species are very simple. For example, a single premium deferred annuity (SPDA) is available with a term as short as one year with guaranteed interest rates. This is similar to purchasing a one year CD at your bank. The advantage an annuity has over a CD is that your interest is tax deferred. Some species in the fixed annuity world are not as simple as the SPDA, but are complex, vague and confusing. These are called indexed annuities and are the products that are being pushed by salespeople using slogans such as “Get all of the gains of the stock market with none of the risk.” They are being hyped like the Titanic but remember… the Titanic sank.

Equity-Indexed Annuities

Let’s start with a little history and an explanation of what Equity- Indexed Annuities are and what they are not. Equity-Indexed Annuities were introduced to the general public in the United States in 1995. The National Association of Insurance Commissioners (NAIC) states, “An Equity-Indexed Annuity is a fixed annuity, either immediate or deferred, that earns interest or provides benefits that are linked to (not invested in) an external equity reference or an equity index.” The NAIC goes on to state, “When you buy an Equity-Indexed Annuity you own an insurance contract. You’re not buying shares of any stock or index.”

An equity-indexed annuity is not an investment. It is an insurance contract that should be called a “fixed” indexed annuity. So, from this point forward we will refer to equity-indexed annuities as indexed annuities since you don’t own equity in any stock or fund.

An indexed annuity is not prone to loss of principal because your money is not in the stock market. However, it is subject to a surrender charge loss which could actually be worse. During the first few years, should you need more than 10% of your current account value, you could be heavily penalized based on the surrender features in your contract. That could be more costly than a drop in the stock market. These charges can be as high as 15-20% of your principal investment!

Potential Risks With Indexed Annuities:

1. Time/Surrender Charge Risk - How long is your money inaccessible before you can get to more than 10% of your account value? 10 years… 15 years… longer? How long is the term? Find that out up front! In an emergency, the penalty to withdraw your money is far more severe than the penalty on a CD. With a CD you lose interest, but with an annuity you could lose principal. Identify the early surrender charges in the contract before signing.

2. Bonus Risk - Many companies entice you with a bonus so you will move money to them. However, they will not allow you to keep that bonus if you decide to move your money away from them at the end of the contract term. This feature is designated to force you to keep your money with them and annuitize it (take a monthly pay-out) at a rate specified in the contract. Again I say: read the contract! The annuitized interest rate is usually 2.5% or less, sometimes guaranteed at only 1%. Additionally, some companies will not allow your beneficiaries to receive a lump sum payment at your death. Your beneficiaries may have to take a five year payout. Was this “minor” detail explained to you? Does that sound like disinformation to you? Currently there are several class action lawsuits involving these types of products filed by Minnesota Attorney General Lori Swanson, and other states are expected to follow.

3. Interest Rate/ Risk- The following insight is worth the price of the book! If your money is spread out in three different indexes (remember, your money is not really invested in the index, but is tied to a formula external to that index), how do you know which index to choose each year to net your best possible return?

4. Index Risk- There are over 40 different methods for calculating and crediting your index returns within the insurance industry. By and large, their formulas are impenetrable. It is not as simple as tying your money to an established index on a specific day and mirroring that return. Also, the insurance company can change how they calculate your indexes each year. They can also change the participation rates, maximums or minimums on your caps, and on and on it goes. The insurance companies understand the importance of keeping their flexibility (changing your participation rates and caps on your annuity). They are acutely aware of the changing market environment. This is why they put clauses in their contracts allowing them to make changes impacting any potential growth in your annuity balance. They do this to secure their profits, not yours.

On top of these, there is an additional risk:

Required Minimum Distribution (RMD) - If your IRA or 403(b) is in an annuity, be very careful when it comes time to withdraw your Required Minimum Distribution (RMD). Many insurance companies will simply send you a letter prior to your turning age 70 ½ asking you if you want to take your RMD. If you do not respond to this letter the IRS will charge a 50% penalty. For example: if you were supposed to withdraw $5,000 and did not, the IRS will penalize you $2,500. If you assume that your insurance agent is taking care of this for you, I have some swamp land I would like to sell you in Florida!

Next - Should I Use a Retail Broker or an Investment Advisor?

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