One product that people should watch out for is the annuity. We are now in a prime environment for insurance salesman to peddle this product. While I am hesitant to paint products with a broad brush, generally annuities are a ripoff and a way for insurance companies to steal your money.
For those that don’t have a general understanding of annuities, I will cut and paste this brief description from eHow.
An annuity works very much like the reverse of life insurance. With life insurance, you pay a small amount over a period of time. If you die during that time, the insurance will pay out a large amount all at once to your beneficiaries. With an annuity, an investor pays in a large amount to the insurance company all at once and then the insurance company pays back the investor a small amount over a period of time. This initial investment is called "funding the annuity" and must be completed before the annuity enters the distribution phase.
I am writing this post because my parents are of retirement age and have been receiving marketing materials and phone calls about these products. They have been asking me about purchasing an annuity. I don’t want to see them get ripped off and I don’t want others to get ripped off either.
I was listening to CNBC this morning and they mentioned that the insurance industry is pushing to permit conversions of retirement accounts into annuities. The financial industry will always be working hard to pick your pocket and the annuity is a great tool for them.
It is not surprising that annuities might be becoming the flavor of the month. The setup for the insurance industry is perfect. Annuities sound very attractive right now. Here is the setup:
- Interest rates are currently at 0%. Short term CDs earn less than 1% and longer term CDs earn less than 4%. While 0% interest rates are good for equities, it is a tough environment for a retiree to pickup a risk free return on their money.
- An offer to receive a fixed sum each money with a theoretical return of 6-7% on your principal investment sounds very attractive.
- An insurance salesman can show a retiree marketing materials touting the safe 6-7% returns their customers received over the past 3-5 years while other investors earned 0-3% in CDs and treasuries. Moreover, insurance salesman can cite that their customers didn’t have to deal with principal losses incurred in stocks and bonds as well as the high volatility.
- The insurance company can guarantee the retiree a fixed payment each money. This adds certainty to retirement planning.
- People talk. Because of this favorable environment, many retirees that purchased annuities a few years back refer their friends to these products. After all, people that bought a few years back feel like big winners. Their principal investment has been stable and earning a return while many have lost money. People that bought annuities a few years back see the disaster that could have been and feel very good about their insurance salesman and their investment. So not only does the insurance salesman have a great presentation because of the volatile capital markets and 0% interest environment, but the referrals and testimonials from their customers are a very powerful sales tool (the people that died and lost a huge portion of their principal investment are not around to talk about it!).
Ok. So what are the potential pitfalls in buying an annuity?
Like any investment, it is possible to win but it is also possible to lose. Annuities are sold as conservative investments but they are actually very high risk products. Here are some pitfalls:
1. Annuities are an insurance product. You are delivering your retirement money to the insurance company and they agree to pay you a fixed sum over time until you die. The insurance company is hoping that you die early so that they can keep your money. In short, if you die shortly after purchasing the annuity, it becomes a horrible investment. The insurance company gets a windfall because they get to keep the money (there are various permutations on how much they get to keep depending on when you die but make no mistake that they do better if you die early). In contrast, if you live until you are 100 it might end up being a good deal.
2. Interest rate risk. Annuities look great in a low interest environment. Think of your annuity as a bond. If it yields a return of 6-7%, it is fantastic in a 0% environment. However, if the risk free rate (ie., short term treasuries, CDs) rises to 8%, you are actually getting a lower return than the risk free rate. Bonds drop in value when the risk free rate rises. An annuity purchased today will also go down in value when the risk-free rate rises. Put another way, it is quite possible that interest rates could rise substantially in the coming years. In the coming years, you might be able to put your money in a 10-year CD and get a yield of 10%. This yield would be greater than the annuity and you would not have to play the insurance game of losing your principal if you die early. You also would not have to pay the fees. CDs and treasuries can also be sold which means you have more flexibility with your money.
3. Fees. Insurance products are expensive. The returns they offer look attractive in this environment but how much are they taking back in terms of fees? Insurance products are almost always heavy on fees.
To sum it up. If you or someone you know does elect to buy an annuity, please understand that the insured is making a bet on interest rates. If interest rates stay low, the annuity could be a good investment so long as the insured lives a long time and the fees don’t eat up the returns. But, if rates rise (which is a pretty good bet with rates at 0%) the annuity will be a terrible investment even if the insured is lucky enough to live a long life and not get killed on the fees (a very big if).
The annuity is an easy product to sell right now, but buyer beware.