Are all Annuities Scams?
Annuities are investment contracts sold by insurance companies. There are circumstances and situations were annuities are appropriate. In fact, for conservative or risk adverse investor, annuities may be ideal. Unfortunately, annuities are often sold in misleading ways, and their purpose is almost always misunderstood by the people who buy them. Incredibly, I have found that many annuity salespeople don’t understand them either. As an advisor, I must often share the bad news about these annuity contracts to customers who simply refuse to believe that they completely misunderstood the product. It is entirely possible that annuities can be sold and used in ways that are quite beneficial, it is also important for the investor understand how some annuities are presented and sold in ways that are misleading and less beneficial for the buyers.
Misleading Annuity Income Guarantees
The sparkly glitter of some annuity contracts is the guaranteed income rider that entices annuity buyers to purchase them.
Industry reports show that over 70% of index annuities are sold with an extra option rider of an income guarantee. Therefore, it is fair to assume that for many people, the major purpose of buying an annuity is the guaranteed income. However, what many do not realize is that, in many annuity contracts, but certainly not all, the guaranteed income rider is close to worthless.
Let’s examine a typical annuity contract, where a 65-year-old annuitant can start a guaranteed income for the remainder of their life at a typical 5% payout rate per year. Some annuity contracts will refer to this as an income stream, and some will call it a 5% withdrawal rate; some annuities will have other, more inventive names for it. What the annuity contract carefully avoids saying is that 5% is interest on the account. However, they leave it to the client to incorrectly assume that this 5% is an interest payment. In other words, the annuity buyer mistakenly believes they are receiving a 5% investment gain or earning 5% interest on their annuity assets.
However, the 5% rate is not an interest rate it is only a withdrawal rate from some cleverly named account such as the withdrawal account or income guarantee account. In actuality, they are likely just getting back their own money. This is because as income payments are made, an equal amount of withdrawal is also made from the cash value of the annuity.
The income guarantee is not an interest payment. It is a planned fixed withdrawal of the annuity’s cash value. In the unlikely event that the annuitant lives beyond the date that the cash is exhausted, then the insurance company must continue to make payments.
If the annuitant lives longer than expected, and the cash value account has been depleted, only then is the insurance company’s own money being used to provide the income guarantee. However, that is normally after the insurance company has had the benefit of using the annuitant’s cash for multiple decades.
The bottom line is the income guarantee withdrawals are not an investment return or based on interest payments, but are instead just the annuitant’s own cash being returned, unless the annuitant lives longer than expected.
People mistakenly believe an income guarantee of 5% on an annuity implies they are earning 5% interest on their money. You may simply be getting your money back, while the annuity company benefits by investing your remaining money.
Let’s review Peter’s situation. At age 65, he begins receiving guaranteed lifetime payouts from his annuity. If he lives to his actuary life expectancy of 85 years old, or another 20 years, then he receives 5% times 20 years, which equals 100%. Peter would have only received 100% of his own cash value investment back. In this scenario Peter receives no investment return. Only if Peter lives longer than expected and fully depletes his cash account will any money be paid from the annuity company’s pocket. However, the insurance company has had his money for twenty years, and has greatly benefited from using it. Paying Peter for a few more years after his cash value depletes is no skin off their back! In fact, some interest would have been credited to his cash account over 20 years, less the cost of the income rider. So, there may be a few more years before his cash account is fully depleted, and only then will he be paid from the annuity company’s own pocket.
Can you believe that annuity companies have the audacity to charge annuity owners a rider fee for a nearly worthless income guarantee? I guess if you charge something for nothing, then it adds the appearance of value.
When Are Income Guarantees Appropriate?
If an annuity buyer understands that the income guarantee is merely limiting the cash value withdrawal rate in exchange for the insurance company’s promise to continue providing cash in the unlikely event that the annuitant outlives the cash value, then the income guarantee may be an appropriate consideration. This is particularly true if the annuitant is in great health and has a family history of long life. In fact, a family history of long life can make an income for life guarantee more valuable.
Income guarantee features may be inappropriate for another reason. Currently, we are in a historically low interest rate period. Raising government deficits will soon almost certainly lead to much higher interest rates. Why would anyone ever consider locking in an annuity’s lifetime income considering that today’s extremely low interest rate assumptions are limiting that income? If future interest rates rise to 10%, limiting your withdrawals rate to only 5 to 6% would be extremely limiting.
I have seldom heard an annuity sales person discuss the potential negative effects of locking in today’s low interest rates.
Phony Money Growth Accounts
Annuity salespeople also promote the withdrawal account or income guarantee account (or some other misleading account name) balance as growing at a guaranteed 6% rate (or whatever) per year until you start taking income. These accounts frequently come with income guarantee annuity policies. I like to call these phony money or imaginary money accounts. However, one must understand this account is not real money that you can withdraw a lump sum from or spend. It is only an accounting number (an imaginary account) that determines what your guaranteed income stream (withdrawals) will be once you turn on that income. Don’t be misled into believing your investment is growing at this rate. This false assumption may be what the insurance company is hoping for.
Annuity companies love to promote how this imaginary account is growing. Why not, if they can confuse you more? Sometimes, they guarantee this imaginary account is growing at 5 to 7%, until you start making periodic withdrawals. How can they guarantee this imaginary account growth? First, there is no real account or money growing. Second, this accounting number can grow higher because it merely reflects the size of your annual payments (withdrawals). Each year you wait to start making withdrawals from the annuity, you are maybe 3 to 6% closer to your death. This means the insurance company has less risk of paying you for a longer period of time. Since they will be paying you for a shorter period of time (until your now closer death) the payout rate can be higher. Remember, this imaginary account is growing because it is not real or available in a lump sum. It does not count as anything more than fluff, designed to confuse and mislead the annuity buyer into thinking they are buying guaranteed growth of their money.
After rejecting the near worthless income guarantee and the imaginary withdrawal account growth, an annuity contract can be useful if one is buying for the right reasons.
Annuities Worthy of Your Investment Dollars
Indexed annuity buyers (and salespersons) are so focused on income guarantees that they ignore the real growth potential of the cash value. Many index annuities are indexed to the S&P 500® with annual caps in the 3 to 5% range. Note your money is not invested in the index, but you may receive an interest credit that is in part determined by the change in the index. With the up-year caps and the down years avoided, many indexed annuity cash values can expect an average performance in the 2 to 3.5% range, a modest but safe investment. If you subtract the annual cost of the income rider, typically 0.95%, the cash value grows even more slowly. However, if the income rider cost is rejected, an indexed annuity may offer an index crediting method that is competitive with and often better than other low volatility investments. Sometimes you can find an indexed annuity that has a crediting method with a proven history of 4 to 7% average returns per year to the cash value of the account. But be careful not to confuse this with growth of the bogus income guarantee account or income withdrawal account. The only real growth is what occurs in the cash value account.
An indexed annuity does offer tax-deferral and protection from the stock market declines while providing the possibility of enhanced interest credits. They typically offer much better returns than most bank rate products.
The cash value is the only currently spendable or real value of an annuity. If an annuity buyer focuses on the cash value growth, some index annuity policies offer enticing index crediting methods that provide for substantial real cash value growth. This growth can be in the 4 to 7% range which is very respectable for safer investments and risk adverse people.
The real growth can be identified by asking the insurance agent to run an illustration of the cash value growth. Remember, you are looking for the real cash value growth and not the income guarantee value or withdrawal account value growth. If this cash value growth is in excess of 5% annually for the last 10, 15 and 20 years, you are viewing an annuity worthy of consideration. This real cash growth can be drawn upon when an income stream is needed or used to purchase a much higher paying bond when interest rates have returned to a more desirable level. A bond can pay interest for the rest of your life.
Some of the better annuity contracts focus on the cash value account growth and offer income guarantees that are free. These are typically the annuities that are most worth of your consideration. The income guarantee can be a nice feature if it does not reduce your cash value account growth due to an attached rider fee. Also you must understand that the stated income guarantee is an inexhaustible withdrawal rate from your cash value and not an interest rate guarantee.
Are variable annuities better than indexed annuities? The high expense of variable annuities typically removes about 2 to 3% of what a direct investment in the stock market would have been. As discussed in Chapter 4, the low return stock market has barely been worth it over the last 18 years. And removing 3% of the gain due to an expensive variable annuity cost certainly will not help. As discussed in Chapters 3, 5, and 6, tax-deferral is not a real advantage. And as this chapter demonstrates, most income guarantees are totally bogus. In conclusion, a variable annuity can be better than an index annuity but only if incredibly high stock market gains endure for many years.
Go to the Calendly.com calendar link to schedule and appointment with and expert, Curtis Hill. Discover how an annuity, structured properly could be right for you. Learn how “Not the Same Old Advice” can benefit you