Three things we do NOT recommend (PART 3)

Annuities – Buyer Beware!

Have you ever considered buying an annuity—maybe during times of market fluctuation? Have you wondered about the pros and cons? If yes, then read on! We will briefly share some perspectives, and—spoiler alert—we generally do NOT recommend them.

The basic concept of an annuity is that you give an amount of cash to an insurance company, and they commit to giving you a monthly payment for a specific period of time. Depending on the level of risk that you take, you would receive different annuity payments.

There are different annuities types, each with different pros and cons. Some may have important benefits for you, but there may be hidden costs/disadvantages that may not be apparent at first. Therefore, making an informed and well-considered decision and speaking to your financial advisor before committing any sizable part of your retirement savings to an annuity is very important. As always, it is essential to NEVER rush into financial decisions!

Here is a summary of the two main types:

1. Fixed Annuities: In a fixed annuity, the insurer guarantees a specific payment amount to the annuitant (the person receiving the annuity) over the contract period. The interest rate is usually fixed for a particular duration, providing stable and predictable income. However, the return may be lower compared to other investments because of this stability.
2. Variable Annuities: With variable annuities, the annuitant has the opportunity to invest in various sub-accounts, similar to mutual funds. The value of the annuity can fluctuate based on the performance of these investments. Variable annuities offer the potential for higher returns but also come with greater risk since the value can decrease depending on market performance.

(There are also some other types, including hybrid combinations of the above.)

In essence, fixed annuities offer a stable income stream with predetermined payments, whereas variable annuities provide the potential for higher returns but with the risk of market fluctuations affecting the payout.

What are the benefits of annuities?

The key benefit of an annuity is the reduction of risk – the risk of market downturns (which could affect investments) and the risk of you outliving your money. Both of these are real concerns for many people, so we don’t want to minimize them. However, we generally take a different approach to address these risks!

What are our concerns about annuities?

Because annuities address risks, they are generally sold by insurance companies. These companies offer good incentives to their salespersons – which can lead them to push you (the prospective buyer) into something that may not be ideal for you. Some annuity sales people play to the consumer’s fear of convincing them to purchase an annuity – using stock market fluctuations to create a fearful attitude towards investing. Additionally, the insurance company’s annuity management costs may be higher than average, which would reduce the funds available to you!

Because sales commissions on variable annuities are generally quite high (6-8%), there is usually a significant penalty (e.g.10%) if you want to withdraw your funds early – i.e. withdrawing more than the agreed amounts, or withdrawing earlier than the agreed timeframe. Unfortunately this often leads to a feeling of being “locked in” when you want to make a change.

Another significant concern is that the annuity payments offered are designed to be “very safe” for the insurance company, i.e. they use very conservative assumptions to avoid making a loss on your annuity. “Safe” for the insurance company could translate into “low” for you as client! So yes, you may get the security of guaranteed payments, but the sense of security may come at a very high price – a significant under-utilization of the capital used to buy the annuity. We could also call this the “Opportunity Cost”, and in the end this may be the #1 disadvantage of annuities.

A National Bureau of Economic Research study found that individuals who annuitize a substantial portion of their wealth may sacrifice potential investment gains that somebody could have achieved in the stock market.

A company that is a fiduciary – meaning they look out for the best interest of their clients – does not typically sell products like variable annuities due to the inherent conflicts of interest.

Our recommendation

Instead of purchasing an annuity, you can minimize your risk by diversifying your portfolio and by planning for the future. It is essential to be intentional about saving money and making suitable, diversified investments to have more than enough in retirement. It might be beneficial to hire a financial advisor who understands the history of the markets and can help you reduce the risk associated with downturns by investing in the long term with a diversified portfolio.

For clarification, this article does not recommend variable annuities. Depending on your unique situation, fixed annuities might be considered. A key difference is that the costs (salesperson commission and management costs) are typically much lower with fixed annuities than with variable annuities. Again, please speak to a fiduciary financial advisor before deciding to purchase an annuity.

Next steps

If you have bought an annuity and want to hire our firm, we will not judge you or make you feel bad about this decision. All too often, potential clients call and ask us how they can get out of their annuities. Buyer’s remorse is common for many who purchase variable annuities.

Many people have hired us who have purchased annuities. If this is you, we will talk it through with you, and we will have a conversation with you so that you can make the best decision moving forward, whether that is to continue to hold onto it or to sell it eventually. We are happy to help you either way!

Disclosure:
The information provided is based on our current understanding and is for informational purposes only. There may be annuity types of which we are unaware and which could mitigate some of our concerns. The concerns about annuity sales staff having potential conflicts of interest and/or recommending products that may not be in the best interest of the typical client is based on general industry information and perspectives and partially based on cases we have seen with our clients. We generally do not recommend annuities, but each client’s situation is unique, and there may be cases in which a client decides to invest in an annuity.

When we recommend against annuities, we may have a conflict of interest. When a client invests in an annuity, this would reduce the investment funds managed by us, and therefore reduce our financial advisory fees.

Please contact us with any questions about the content above or to discuss your situation.