Have you ever gone shopping for a cell phone and get the sense the salesperson you were dealing with was overzealous about a particular brand?
Ever felt pushed hard toward a certain brand even though you perceived it as being inferior to other available options?
The salesperson shouted from the rooftops about all the benefits of such and such phone while tearing down a competitor’s phone. Meanwhile, drawbacks of the featured phone were completely ignored.
Then something occurred to you as you looked around the store. You realized you were not alone; every other salesperson in the store was pushing the exact same brand on their customers.
The dirty little secret about cell phone sales – in fact, this is also true with a lot of other consumer products that are peddled by sales personnel such as automobiles, furniture, appliances, etc. – is that these salespeople are incentivized to push certain brands. They’re incentivized by the manufacturers themselves to promote their products in exchange for some financial kickback on the backend.
Of course, the salesperson is there to make money, so if he can make a kickback on top of his standard commission, he’s going to push the product that will put the most money in his pocket. You can’t blame him. He has a family to feed too, but for the consumer, you should be cautious with overzealous salespeople and be aware that what they think is a great product and a great deal may not, in reality, turn out to be a great deal or a great product for you, which brings us to the subject of annuities.
Annuities are products of insurance companies peddled by their agents.
Did you know that annuities pay extremely high commissions, often 7% or higher? That means on a sale of a $200,000 annuity, an insurance salesperson can earn $14,000, all up front.
It should come as no surprise then, just like the cell phone salesman who has added financial incentive to sell a particular brand of phone, the insurance salesman has substantial incentive to push you towards this one particular financial product because the incentives are too great to resist despite the product’s inferiority.
And, just like the cell phone salesperson, the insurance salesperson will only tout the benefits and ignore the drawbacks. Unfortunately, annuities don’t offer much in terms of pros but instead are racked with cons. There’s a reason why insurance salespeople ignore the disadvantages of investing in an annuity, and that is because, with all things considered, an annuity is one of the worst investments you can make, right up there with your uncle’s can’t miss Ponzi scheme, because that’s what annuities are, scams.
Insurance salespeople use scare tactics to sell annuities, and that should scare any potential investor away from ever putting money in one. The one fear every salesperson instills into every potential client is the fear of running out of money in retirement.
They claim, with an annuity, you’ll never run out of money. The one so-called advantage every insurance salesperson will tout is the guaranteed monthly income the holder will receive once he reaches retirement age. No matter the state of the economy, the salesperson touts, “you will always get paid, and your principal will not lose value.”
Protected principal and a fixed income sound nice until you dig a little deeper to expose the ugly truth.
Before we get into the drawbacks of annuities, it’s important to discuss the principle differences between the two main types of annuities, fixed and variable annuities.
Fixed annuities are very much like a bank CD. You deposit a sum of money, and the insurer agrees to pay a certain interest rate over a specified period. Supposedly, you’re protected from downside risk in that your principal is contractually guaranteed.
Variable annuities, on the other hand, are more like mutual funds and can go up and down with the market. However, there are some significant differences between annuities and mutual funds that make choosing mutual funds over a variable annuity a no-brainer.
With the differences between fixed and variable out of the way, here are the primary reasons why you should avoid annuities:
1. Limited Upside
With fixed annuities, in exchange for the security of a monthly income, you give up most of the upside on your investment. Fixed annuities protect principal but also limit the upside. Some fixed annuities allow the holder to participate in the upside of their investment; however, they usually cap it at around 4% per year.
So even though it’s true if the market falls 20%, the investor won’t lose any money with a fixed annuity, on the flip side, if the market gains 20%, in most cases you will not participate in the upside. If you do, you’ll be limited to 4%.
With fixed annuities, even with the highest paying offerings, the most you will top out at is 4% per year. Factoring in inflation, that 4% on your principal in today’s dollars, may not be worth much when you retire in 20 years.
2. Fees & Expenses
Some compare variable annuities to mutual funds, but there’s one big problem with that comparison. Even though you can enjoy more upside than with fixed annuities, variable annuities are saddled with additional management fees not associated with mutual funds.
These high fees, usually known as insurance costs or M&E (mortality and expense) charges, result in higher annual operating expenses than mutual funds. Average annual expenses are up to three times higher than a typical mutual fund’s expenses, sharply reducing your future investment returns.
3. Taxes and Penalties
Annuity distributions are taxed at ordinary rates. The monthly distribution on a fixed annuity is taxed just like interest on a CD. That fixed annuities are taxed like CDs is not unexpected. That variable annuities, invested like mutual funds, are taxed at ordinary rates when money is withdrawn should make every potential buyer of annuities run for the hills.
So on top of the already high management fees, you’ll more than likely pay more in taxes when withdrawing your money at ordinary rates instead of the capital gains rate you’d pay from withdrawals on your mutual funds. On top of the obvious tax disadvantages of investing in annuities, the various penalties associated with annuities should also deflate any enthusiasm for these products.
Annuities are contracts that require you to hold them for a minimum amount of years (i.e., surrender period) before the guaranteed payments kick in. If you withdraw your money within this surrender period, you’ll incur early withdrawal penalties. Surrender periods vary from two years to 10 or more, and the corresponding charges typically decline with time.
For example, a deferred annuity with a 10-year surrender period would charge 10 percent on money withdrawn the first year, 9 percent the second year, 8 percent the third year and so on. On top of the early withdrawal penalty, if you make a withdrawal before age 59½, you’ll be subject to a 10 percent federal tax penalty. With these types of penalties, annuities are designed to keep you in for life.
4. Their Guarantee is not Exactly a Guarantee
Unlike bank deposits that are guaranteed by FDIC for up to $250,000, annuities are not federally insured. The insurance companies themselves make the guarantees, and those guarantees are only as secure as the insurance company making them. If the insurance company goes belly up, you’ll be out of luck.
5. About That Guaranteed Income
It doesn’t sound so great when you really dig into the math. For example, if you bought an annuity at age 35 that doesn’t start paying until age 65, you’re tying up your money for 30 years. For what? The chance to make a maximum of 4% a year on a fixed annuity, taxed at ordinary rates? Variable annuities aren’t much better as outrageous fees absorb any potential upside.
To illustrate how bad annuities are as an investment, especially for retirement, consider the performance of the S&P 500 over the past 30 years, which had an average annual return of 6.73%. You’d be far better off putting your money in an index fund for 30 years and letting that money compound so by retirement age, your return will far exceed the 4% return on a fixed annuity, and you will enjoy the advantage of your withdrawals being taxed at the capital gains rate instead of at ordinary rates with annuities.
Like a subpar cell phone pushed by an overzealous salesperson, annuities are subpar financial products pushed by overzealous insurance agents who stand to make a killing on commissions if they sell you one. They prey on the fear that you’ll run out of money in retirement if you don’t go with something that pays you a guaranteed fixed income.
You may want to think twice before considering annuities as an investment. I can’t think of one person annuities would benefit and the only ones profiting from them are the insurance companies and their agents selling them. Don’t fall for their incentivized sales pitch.