As the stock market has moved through gyrations the last few months based on fears about Greece, interest rate hikes from the Fed, and slowing GDP growth in China, some investors may answer the siren song from a broker touting a variable annuity. Hearing the pitch about “income for life” that is not completely dependent on market returns is pretty appealing these days. Your advisor has a strong incentive to sell you one as this product has high sales commissions. For some advisors, this is their “go to product” for all clients. I would call this type of advisor an “Annuity Shark.”
Annuities are not for everyone. The product is appropriate for investors who need additional investments to defer taxes on gains and income or need the assurance of a payout over their lifetime while minimizing the amount of funds that go to their heirs.
A basic primer on two of the components a variable annuity provides gives a baseline to discuss the product. The first component is the one you write your account deposits to. Working with an advisor you decide how to invest the money for growth in the annuity. This account is called the market value of your contract and is where your annual administrative fees are pulled from. Typically, a 3% or more annual fee for the base contract and an income rider if you have one.
If you purchased an income rider, you have what the annuity company calls your income base account which I sometimes call the “funny money” column. The value of this account starts with your deposits into the annuity. On many riders, the annuity company will make an agreement to increase this column say 5% per year for a period of 10 to 12 years or to the first year you decide to take income from the contract.
If the market account value increases in any given year, some annuity companies will credit the 5% increase on top of the market value column increase in the income base account. This is where the agent tells you that you will get account growth even if your market value account in the contract falls. However, if you decide to terminate the contract after the surrender period, you get back the market value of the contract, not the value in the income base account.
Once you start to draw income on the contract, the annuity company may pay a 65 year old 4.5% as annual income off the income base column. Sounds great, but the annuity company will be giving back your money first, taking their contract fees and income payouts (typically 7.5% a year; 3% for the contract & the 4.5% income payment to you) from the market value account which holds the money you put into the contract and the returns you generated on the investments. This is a scenario where your kids are most likely not going to inherit anything from this product after a 20 to 30 year income draw period.
Your market value side of this contract has to return over 7.5% every year to prevent the erosion of the market value portion of your contract which at death would go to your beneficiaries. Keep in mind some annuity companies are going to require that your invested funds have a certain % of fixed income and equities for the underlying investments. These percentages could very easily impact the growth on both accounts in your contract. On most contracts if the investment side of the contract does go to zero, the annuity company will continue to pay you the income benefit and your beneficiaries will get nothing. That is where the agent comes up with the expression “income for life”.
A second issue to consider is that once you start getting payments in this scenario the 5% annual bump stops in the income base account and the contract in the first few years has to exceed the 7.5% being pulled from your account to see an increase in the income payment you are receiving over the years. The likelihood of an income increase is small. So for a person who starts his income at age 65 on an annuity which generates a $50,000 income payment per year will most likely never see a dollar increase on this payout. Twenty years later this $50,000 payout with 3% inflation will have $27,189 in purchasing power in today’s dollars.
Confused? Do not be embarrassed, every time I call an annuity company for a potential new client to understand the contract, it takes me some time to sort out what the ramifications are for the client. If you own an annuity or are considering one some key questions to ask are; if I terminate the contract what are the penalties? How does the contract have to perform for me to see an increased income payment in retirement especially after I start taking income and the income rider is no longer building my income base account? What are the total annual fees being pulled from my market value account every year? If you are looking to pass any money to your heirs, what is a realistic projection for your market value account after fees and income distributions at a projected death date?
Again, for some people this product may be appropriate, but do take the time to understand how this product fits your planning goals and how the fees may impact the income you receive 10 to 20 years down the road.
If any of these scenarios are unacceptable to you, stick with your diversified portfolio through the ups and downs of the market. Have courage in down markets and faith in the future in markets here and abroad. If you find yourself wavering, avoid the “annuity sharks” and find an advisor who has a long term outlook around your planning goals and can talk you through down markets.
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As a Financial Planner, Peter brings three decades of consumer product industry experience and a high level of customer service to the financial services business. After a successful 25 year sales career at Blistex, Inc., he was employed at Morgan Stanley as a Registered Marketing Associate and Financial Advisor from 2010 to 2013. Peter believes in diversified portfolio management to meet college savings goals, retirement lifestyle objectives, charitable giving goals, and estate planning objectives.
Peter is involved in his local community in Annapolis, MD. He has served on the Vestry and chaired six Stewardship Campaigns at St. Anne’s Church. He currently supports St. Anne’s as the Planned Giving Committee Chairman. He has been active in local Boy Scout units and also serves on the Board of the Trustees for the Chase Home in Historic Annapolis on the Endowment Committee.
Peter and his wife Molly live in Annapolis, MD and are “empty nesters”. Their son, Hunter, graduated from the University of Mary Washington in Fredericksburg, VA and their youngest son, McLean graduated from Belmont University in Nashville, TN.