Why Annuities Are Often Sold, Not Bought

PHOTO: Annuities provide an income stream in retirement, but the costs can be high compared with the benefits for many people.ArtisticCaptures/Getty Images
Annuities provide an income stream in retirement, but the costs can be high compared with the benefits for many people.

If you have substantial assets or suddenly come into money through inheritance or a divorce settlement, there’s a good chance that someone will try to sell you an annuity.

Annuities are highly complex investments that are marketed aggressively, often to individuals for whom they may not be appropriate. Investors usually don’t go looking for an annuity. Instead of being sought, these investments are sold.

In an annuity, the investor hands over a substantial lump sum to an insurance company in an arrangement by which the company is ultimately obligated to provide an income stream for life. There are various types of annuities, many of which aren’t right for anyone.

However, some annuities have a purpose for some individuals, particularly if they have a critical need for a life-long income stream. For this income stream, annuity buyers pay substantially. But this may be worth it for those who lack a retirement income stream.

The main reason you may be solicited for this product is that commissions for them are often 6 or 7 percent or more of the total investment. At this rate, if you invest $500,000 in an annuity, the salesperson earns $35,000 — possibly in one afternoon.

This powerful financial incentive motivates various types of financial people, especially brokers and insurance reps, to search high and low for prospects. Because annuities require the buyer to write a large check, prime sales targets typically include women who have recently inherited money, collected insurance proceeds or received a divorce settlement. Prospects also include well-heeled clients of financial professionals (including brokers), who are well aware of the money these clients could readily invest in an annuity. The less these clients know about financial matters, the more vulnerable they may be to sales pitches for annuity products that aren’t right for them.

Even if a person trying to sell you an annuity calls himself or herself an advisor, he or she is under no legal obligation to serve your interests beyond determining that an annuity is “suitable” for you — a relatively low standard. Advisors who are classified as fiduciaries are required by law to meet a much higher standard: to always put clients’ interests ahead of their own. Those who may try to sell you an annuity aren’t pure fiduciaries.

This isn’t to say that fiduciaries don’t help clients acquire an annuity if it’s an appropriate investment for them. But anyone who stands to gain a commission for selling you an annuity isn’t acting as a pure fiduciary. At that point, they have taken off their fiduciary hat and are operating under regulations that don’t require them to put your interests first.

Like most sales pitches, those for annuities convey a great sense of urgency, as though a decision to buy this product must be made quickly. And, as usual, there’s no urgency at all. Those who delay getting an annuity are at no disadvantage. And usually, disadvantage comes to those who decide to buy them.

For women who are financially empowered and diligently and competently managing their finances situations, any type of annuity is probably the wrong choice.

Yet some annuities can have advantages for investors who aren’t engaged enough in managing their money or don’t have a qualified advisor. They provide a set-it-and-forget-it option that frees buyers from worrying about what the markets are doing; they will get a minimum guaranteed amount no matter what, assuming the insurance company stays solvent.

The downsides of annuities include:

  • High fees. These fees start with sales commissions, which investors ultimately pay indirectly. Atop that, there are typically expenses stemming from optional guarantees and add-ons for increased flexibility, as well as from mutual funds in which your money may be invested under the arrangements of some annuity products.
  • Low gains relative to other investments. In some cases, depending on the rate of inflation, there may be no gains at all. Investors can often get far better returns, while keeping risk low, by maintaining a diversified portfolio of stocks, bonds and other investments.
  • Lack of access to your money. Once you buy an annuity, you can no longer get access to this money for a set period, unless you pay a huge surrender penalty. Ultimately, you have no access to your money whatsoever because it becomes the insurance company’s money. As a result, you could end up lacking funds you might need in an emergency, or paying dearly to get them. Stocks and bonds, on the other hand, are highly liquid, so you always have quick access.
  • Irrevocability. After you trigger an annuity’s income stream, you’re locked in for life; there’s no changing the arrangement.
  • A potential nightmare for your heirs. In most cases, once you trigger the income stream, your investment is off the table for estate purposes. If you die the day after the income stream starts, your heirs will get nothing — no income nor any part of your lump-sum investment. Insurance companies try to make some annuities more appealing by offering riders that assure that your heirs will receive some of the money you invested. But these arrangements are usually quite expensive for you and for your heirs, who usually receive less money than they would if you’d never purchased the annuity. As people who buy annuities often invest a large percentage of their assets in them, this can severely reduce the amount of their net worth that their heirs receive.
  • Company risk. Investing a lot of money with one company can significantly increase your risk of loss. Those who decide to buy an annuity should limit their investment to a manageable portion of their total assets. That way, if the company holding your annuity goes belly-up, you would have other assets.

Damning as this is, annuities hold advantages for some people. For one thing, they provide asset protection from creditors and court judgments in many states. Because of this, some people who are frequent litigation targets, such as physicians, are inclined to purchase annuities to protect their assets in cases where judgments exceed the maximum of their malpractice insurance coverage.

Even for those who lack this kind of business purpose, some annuities may be a good idea. These people include those who are concerned about longevity risk, the prospect that they might outlive their assets, because they don’t have a pension and aren’t eligible for Social Security benefits.

Good candidates for annuities also include people who:

  • Simply can’t handle their finances with any competence and don’t want to bother investing in the markets. Without an annuity, these people might have their money in a savings account, where it would be eaten up over time by inflation.
  • Have severe problems with overspending, gambling or substance abuse to the point of dysfunction.
  • Have grown children who might get access to their assets and drain them irresponsibly, threatening their parents’ retirement security.

For these people, a single-premium immediate annuity (a type of fixed guaranteed annuity) might make sense. This is one where investors pay a lump sum in exchange for a guaranteed income stream that starts right away. Yet this isn’t the kind of annuity that financial people will probably try to sell you because sales commissions for them are relatively low.

Instead, they are more inclined to sell you a variable annuity or an index annuity. In this type, after an accumulation phase, the insurance company guarantees a minimum payment, with the possibility for amounts above that minimum depending on the performance of a managed portfolio of investments held by the insurance company.

At first, variable annuities can appear quite appealing, but they are rarely a wise choice for anyone. Some varieties include a guaranteed withdrawal benefit. This typically allows you to withdraw a set percentage (for example, about 4 percent) of your initial account value as long as you live. Some even offer a guaranteed rate of return before you start drawing income. And since your money remains invested in the annuity’s subaccounts, which operate much like mutual funds, there’s a chance your account value and future income stream might increase. Perhaps the biggest draw is that your income won’t be disrupted if the financial markets get pummeled as they did in 2008–09.

However, the onerous fees typical of variable annuities whittle away at your account value, making these poor investments. Unlike fixed guaranteed annuities, variable annuities may not assure a minimum amount of income, and the heavy fees they charge can eliminate the upside that buyers purchase them to get.

But instead of using any type of annuity, you could be investing this money yourself with total flexibility and potentially higher long-term returns with a well-thought-out diversification strategy.

The fundamental irony of annuities is that you shouldn’t buy one without understanding it. But if you could truly understand annuities, you’d probably have enough basic financial wherewithal to maintain a market portfolio or engage intelligently and prudently with a qualified, ethical financial advisor. For most people, this is usually a superior option to buying an annuity, assuming that you build and properly maintain a highly diversified portfolio so it can withstand market declines.

Regardless of what you do when you’re approached by an annuity salesperson, take your time and get all the facts before signing on the dotted line.

Any opinions expressed here are solely those of the author.

Laura Mattia is a partner with Baron Financial Group, and a fee-only financial advisor. She's a Certified Financial Planner professional (CFP®), a Chartered Retirement Plan Specialist (CRPS®) and a Certified Divorce Financial Analyst (CDFA™) and holds an M.B.A. in accounting/finance. Her Internet radio show is Financially Empowering Women™ with Laura Mattia. Having worked as finance professor at the Rutgers University Business School, Mattia is doctoral candidate in financial planning at Texas Tech University. Her research is focused on understanding why women are not as financially literate as men.