As our firm continues to grow, Andy and I are visiting with more and more clients who own some form of an annuity contract. This is usually revealed to us at the beginning of a client relationship with a series of questioning statements, such as:
“I bought this annuity, but I really don’t understand it.”
“The person who sold it to me told me it was a good investment.”
“I am supposed to earn x amount of interest for x amount of years.”
The majority of our clients purchased an annuity because they were under the impression that it was the only or best option available to them at that moment in time. The fact is that annuities are not for everyone. And, annuities should never be presented as the only available option for a client, particularly those with limited assets.
Andrew Hill Investments holds both the combined knowledge and access to the resources of Fidelity’s Annuity Service Department, giving us an edge on the market. So far, our firm has reviewed at least 20 different annuities. During this process, we review the pertinent terms of the contract, analyze the underlying investments, fees and expenses, and then compare the existing annuity to other alternatives. The benefit to our client is that they receive an annuity review in “plain English” format.
There are hundreds of variations of annuities, some of which defer income and others that pay immediately. The underlying investments may be variable, meaning they sway with the markets, or fixed, so that investors get a return. Insurance companies also may add layers of “benefits” (such as guaranteed income, death benefits, etc.), all of which have their own terms, conditions and expenses.
- Fixed-income annuities typically pay between 3-4 percent more than the 10-year Treasury bond. Your initial premium (investment) is returned throughout your annual payments. If you die young, you will collect less income. If you die later in life, you will collect more income. This type of annuity may be appropriate in addition to a client’s overall fixed-income allocation, but should not be a substitute. Clients should always prepare with guidance, as they may need the funds for unexpected spending.
- Deferred-income annuities are structured the same, but the income payments start at a later date. The longer you wait, the higher the income stream will be.
- Indexed annuities promise a guaranteed minimum payout. The premiums paid are then invested in various index funds. The caps on the interest are usually 4 percent; therefore if an index returns 10 percent, you only receive 6 percent. For this reason, these types of annuities are not as popular. Liquidity can be a problem with indexed annuities as they have “surrender periods” (or waiting periods) before you can access the funds without incurring a penalty charge. Surrender periods range from 7 to 10 years, although I have seen some contracts stretch out to 20 years.
- The most common type are variable annuities. According to Barron’s, variable annuities are a $138 billion business. Variable annuities were originally intended to be a form of asset accumulation allowing for tax deferred accounts to be invested in a basket of mutual funds. As with an IRA, funds can’t be withdrawn without penalty until age 59 ½, otherwise all withdrawals are subject to ordinary income tax. This varies from dividend or capitol gains, which fall under different guidelines that are viewed as unfavorable. Therefore, this type of product appears to be suitable for those clients who do not have qualified plans (IRA or 401(k) accounts). Most of the variable annuities that we see, however, are IRA variable annuities. I continue to be puzzled as to why a financial advisor would recommend this option. Perhaps, it is because 80 percent of variable annuities are sold with riders or add-ons to the original contract. One of the most popular riders is a guaranteed income rider. Assuming the investments perform, there may be upside potential, however, the terms under most of the riders are complicated and the downsides may not be immediately clear.
- Fees- The average contract cost for an annuity contract is approximately 1.5 percent. Add an income rider, and the fees will push up to 2.5 percent. Mutual fund management fees are typically in excess of 3 percent. The math is not overly difficult – unless the underlying investments return more than 7 percent per year, all of these fees will eventually deplete the account. Due to the low interest rate environment, insurance companies have started trimming down guarantees, increasing fees and requiring a portion of the investments to be held in low-volatility investments. In my opinion, only those investors who are looking for an additional tax-deferred vehicle should consider a variable annuity. The focus should be on tax-deferred savings, not guaranteeing income.
- I am not completely opposed to annuities. As I mentioned earlier, an income for life annuity may work well within a client’s overall fixed-income allocation. However, I am in opposition to financial advisors who fail to explain the pros and cons of annuities. It is easy for a client to remember hearing phrases such as “guaranteed income for life” and “4 percent yield”, all of which are definite “pros” from a client’s perspective. An advisor who fails to disclose “cons” (surrender periods/penalties, mutual fund expense ratios, rider fees), or downplays the downside, is clearly not acting in his client’s best interest.
- Service or lack thereof. It appears that clients are misled when it comes to service. An annuity is a product. Unlike traditional investment accounts, which require active management, on-going review and servicing, an annuity is a “one and done” from the advisor’s perspective. For example, if a client needs to change an address or update a beneficiary form, they are directed to the insurance company’s 1-800 numbers. The original advisor (salesperson) does not get involved in these functions.
Please do your homework before even considering the purchase of an annuity. Annuities are not for everyone. Contact Andrew Hill Investment Advisors today for a review or your portfolio or to learn more about the investment strategies that we regularly secure for our clients.
By Jennifer R. Figurelli, CTFA