What are annuities?
October 4, 2005 8:41 AM   Subscribe

What are annuities and why should I be wary of them?

My mom has inherited a good amount of money in a trust and has been approached by a good friend who is a financial advisor and wants to put her money in an annuity. This person says that the principal is guaranteed and can never be lost. Number one, I don't believe that for a second. Number two, I'd heard bad things about annuities, but don't really understand what they are. What are they, what should I look out for and what are the specific risks?
posted by spicynuts to Work & Money (27 answers total) 1 user marked this as a favorite
Annuities often have significant commissions, and your mom should be wary. Annuitization
posted by theora55 at 8:53 AM on October 4, 2005

The only reason an annuity is a good idea is that you are guaranteed income on an annual basis. You can create something similiar yourself by purchasing T-Strips or CDs that mature on a regular basis. The principle is secure, you earn interest, you can get to your money easier (i.e. resell them if you need $ now), you don't pay large commissions, and you basically don't get screwed by a broker looking to make easy money off of your money.
posted by blackkar at 9:10 AM on October 4, 2005

Annuities come in eight major varieties: Combinations of Immediate/Deferred, fixed/variable and period-certain/life.

I'm guessing that your mom was pitched an immediate fixed annuity with life payout. The stream of payments is guaranteed by the issuer (usually a life insurance company)and (probably) by some state reinsurance fund.

The nice thing about a fixed life annuity is that you're guaranteed a certain payment every month as long as you live. If you buy from a discounter, payouts to the sales agent aren't really that high.

Most of the bad press on annuities comes not from the immediate fixed variety (though the IRR of such products is underwhelming), but from the variable deferred version-- which is like buying mutual funds (usually) in an expensive, tax-deferred wrapper. These are frequently sold to people who pay more in premiums than they receive in tax benefits, hence the criticisms.

Everything blackkar says is correct, but he overlooks two things: reinvestment risk from maturing bonds (rates not guaranteed), and lower cash flow (all immediate annuity payments include some return of principal).

The ideal client for a fixed immediate annuity is someone who wants maximum risk-free cash-flow and doesn't care about his or her heirs.
posted by Kwantsar at 9:16 AM on October 4, 2005 [1 favorite]

Also, if I guessed wrong, and the salesman is pitching a variable deferred annuity, the principal is guaranteed, to a point. If mom plunks $500,000 in the annuity, the market tanks, and she dies, the heirs will get a minumum of $500,000 no matter how low the investments have dropped.

If mom misallocates the money, loses $100,000, and tries to (while living) get all of her $500,000 back, she's screwed. Hence the guarantee.
posted by Kwantsar at 9:19 AM on October 4, 2005

How old is your Mom? That will have a big impact on whether a particular annuity makes sense. Many annuities tie up your principle irrevocably in return for the gauaranteed monthly payments. If someone is very old, that usually doesn't make sense.
posted by alms at 9:26 AM on October 4, 2005

Reinvest risk would be relatively low right now (rates are bound to increase, they are extremely low right now) - as well as any percentage points not paid to the broker would be akin to a higher rate of return. Also, you are not required to reinvest the maturing investment, you can hold it in a money market account until the market regains, etc. whereas an annuity would give you no option to change the underlying investment. If the broker signed you up for a 6 percent annuity and the market came back and she could easily get 8%, she wouldn't be able to swap her original annuity to the higher rate without at least some sort of penalty (or at least have to pay the broker fees all over again).
posted by blackkar at 9:38 AM on October 4, 2005

Response by poster: My mom is 64. Her mom lived to be 95. Her mom's mom lived to be 102. Let's say for argument's sake there is more than 500K involved. She gets Social Security and a bit of pension from my dad's time at work. There is no mortgage. She could easily live off of the Social Security she gets. The goals in my mind, with this money, are, in order of priority:

1) Reduce any tax burden on the current set up, which is the bulk sum in a money market account in the estate's name with my mom as executor

2) Grow the principal or at least guarantee it for handing down to heirs (my bro and I)

3) Provide an additional income should my mom want to increase her lifestyle

I personally don't see how tieing up the entire principal for an income stream that is not immediately necessary is the best choice for number 1, which is what I see as the only real benefit of this. Do annuities actually GROW the principal in any sense or are they simply using whatever earnings the investment generates to pay the yearly income?
posted by spicynuts at 9:39 AM on October 4, 2005

Also, many annuities aren't created with concern to taxes. This may make a huge difference in the long run for your mom and/or anyone that tries to cash out the annuity later.
posted by blackkar at 9:39 AM on October 4, 2005

I am under the impression that they only pay out, they do not grow the principle (I may be wrong on this though). An excellent source for info is www.fool.com - they have a lot of Q&A and FAQ sections and forums that you can post this question on.
posted by blackkar at 9:41 AM on October 4, 2005

Response by poster: Thanks guys for everything so far. This is excellent.
posted by spicynuts at 9:49 AM on October 4, 2005

Do annuities actually GROW the principal in any sense or are they simply using whatever earnings the investment generates to pay the yearly income?

I stress, again, that you've asked about "annuities" without specifying the type of annuity that's being pitched. That makes your questions tough to answer. Deferred annuities are designed to do such a thing, but don't make sense for lower-income people.

As far as reducing the tax burden (I presume that you mean "income tax burden"), I suggest that you do a TEY calculation to see whether she should be in a municipal money market. If you buy bonds, you'll need to make the same calculation between munis and corporates/treasuries.

As far as your other needs, if a "guarantee" is so important, I suggest peeling off, say 10% of the money to a money market, so your mom can take income from it if necessary. With the remainder, you may wish to place a certain percentage in a treasury zero-coupon bond that will grow to a specified amount in a specified time, and place the remainder in an equity index fund.

Really, what you need to do is see a qualified professional, like a fee-based financial planner.

Reinvest risk would be relatively low right now (rates are bound to increase, they are extremely low right now)

That's what people said four years ago.
posted by Kwantsar at 9:52 AM on October 4, 2005

I would recommend a fee-only planner instead of fee-based to eliminate any bias towards products or services. Also, interest rates should not be looked at in 4 year increments - I would recommend purchasing a 10+ year ladder if you are really concerned about a 1 or 2% difference in a 4 year time frame (it would only be on a portion of the money as well, not the entire investment).
posted by blackkar at 10:25 AM on October 4, 2005

and has been approached by a good friend who is a financial advisor and wants to put her money in an annuity

Two things scream out at me from this.

One, "approached by" - someone coming to you is selling something and very possibly victim to the disease one gets when holding a hammer that makes everything look like a nail. Good financial advice examines a huge swath of options and situations. There is no one-size-fits-all.

Two, "good friend" - no better way to get yourself an estranged friend than to take a good friend and add a business relationship. Doesn't always turn out that way but personally I'd be reeeeeal careful. I don't want to look at any of the people close to me and be reminded of how I lost some money or failed to get as good a return (same thing in my book) on an investment.
posted by phearlez at 10:40 AM on October 4, 2005

My point, blackkar, is that people who try to outthink the term structure of interest rates are fools or speculators. And someone (especially someone with an MBA) shouldn't be on AskMe explaining that "rates are bound to increase" without any context.
posted by Kwantsar at 10:43 AM on October 4, 2005

Response by poster: I stress, again, that you've asked about "annuities" without specifying the type of annuity that's being pitched.

Understood, Kwantsar. I am meeting with the woman tonight to get more details. As of right now, I do not know what kind of annuity is being pitched.
posted by spicynuts at 10:46 AM on October 4, 2005

Your bank likely has a financial advisor who will give you free financial information specific to your case. They will be looking to sell you something, but you can at least get a different perspective. Annuities can be good investments, if she doesn't want to touch the money. Just remember, your best bet it almost always to diversify. Look into putting a fraction of it into a single-premium whole-life product (ours was called the Estate Maximizer) if she wants to set some aside for her heirs tax-free. If she lives another 30 years, the payout on that could be quite good, even adjusted for inflation. Keep some in an index fund as well.
posted by Eideteker at 11:27 AM on October 4, 2005

Why should senior citizens be careful of annuities? In the case of my grandpa, who may be a plaitiff in a class action suit for senior fraud, they're often sold to elders disguised as life insurance. After his wife died, he discovered the money was locked up in the annutity, contrary to what had been pitched to him.

Can't remember the name of the case, but it has been giving annuities some bad press.

Yours sounds like it could be more honest...?
posted by johngoren at 11:30 AM on October 4, 2005

Look into putting a fraction of it into a single-premium whole-life product (ours was called the Estate Maximizer) if she wants to set some aside for her heirs tax-free.

Not a bad strategy (talk to an attorney to see if you need to register this insurance in an ILIT), but remember that the future of the estate tax is unknown, and you may be paying needlessly (again) for insurance.

Reason #1,428 to seek the advice of a qualified professional.

Also, spicy, if you feel like sharing where you live, I may be able to make a YMMV referral. I used to know a lot of people in that part of the business.
posted by Kwantsar at 11:41 AM on October 4, 2005

If you are talking about something more than $500k and there are potentially competing uses for the income/principal, skip your bank's financial planner or anyone else who gets paid commissions or any sort of product based compensation. Go straight to NAPFA or Garrett and find a local fee-only planner. Their upfront cost may seem a little higher but at least you will know the cost. There will be no hidden fees or commissions eating up your principal.
posted by cyclopz at 11:50 AM on October 4, 2005

"Second, equity indexed annuities sound good – offering equity-like returns with no downside – but the sales reps seldom detail the fine print. Although there is great variety in contracts, virtually all have some provision setting the maximum return you can have in any given year, limiting your return to the price change in the index (which means the dividend yield is excluded), etc. Lots of stock sizzle, not much steak.

One highly consistent thing about equity index annuity contracts, however, is that virtually all offer a high commission to the sales rep. I'd bet heavy money that the commission burden on this proposal is in excess of 10 percent – that's $30,000 of your money.

Your $300,000 401(k) account should get you good advice, personal attention and real analysis from a person with both a conscience and training. And you should expect your planner to be paid for her time and skill.

A CFP who provided service and tried to deliver good investment options for his clients, for instance, might direct your $300,000 toward the American Funds group. Although the commission on small purchases of front-loaded "A" shares is 5.75 percent, the commission rate is reduced as the purchase increases. For purchases over $250,000, for instance, the commission rate is 2.5 percent.

That's $7,500. Few would call that small change.

The sales rep does not receive 100 percent of this amount, but the amount he receives should buy you 50 hours of $150-an-hour professional planning advice or 25 hours of $300-an-hour professional planning advice. Either way, a real financial planner can guide you to an investment plan with low annual costs and a good track record while being well compensated.

How well compensated?

In a typical professional services business in which direct wages represent about 40 percent of revenue, a services fee of $150 to $300 an hour represents an annual salary of $120,000 to $240,000 a year.

Few would call that small change, either. "
posted by letterneversent at 12:16 PM on October 4, 2005

Response by poster: Kwantsar, I live in Park Slope, Brooklyn. My mom lives in Poughkeepsie, NY. Recommendations in either area are welcome.
posted by spicynuts at 12:43 PM on October 4, 2005

One thing to watch out for with annuities is that sleazy "financial planners" will conflate interest payments with return of principal. That is, they'll claim you're getting a guaranteed 10% return (which beats the hell out of anything right now), but they don't tell you that 8% of that 10% is your own money coming back to you. At the end of 20 years (or whatever), you wouldn't have your initial investment any more, it would have been paid back to you piecemeal over the life of the annuity.

This doesn't make annuities a bad investment. If you can calculate your expected lifespan effectively, you may want to distribute your investment over your remaining life. But claiming it as a 10% return is just a lie. I had exactly this experience at E.A. Buck in Honolulu.

I'll second (or third) what's already been said, get a financial planner who takes a flat-fee upfront and no commision.
posted by zanni at 4:33 PM on October 4, 2005

Forbes has a lot of (bad) things to say about annuities. Here's one recent example. There are plenty more if you search their site.
posted by ZenMasterThis at 7:38 PM on October 4, 2005

Response by poster: Forbes has a lot of (bad) things to say about annuities. Here's one recent example. There are plenty more if you search their site.

The linked article refers only to deferred annuities, which I learned last night is not what is being pitched:

"(I am talking only about the most common form of annuity--the deferred annuity sold as an investment account."

If anyone is still following this thread, here is what was pitched: Allianz MasterDex 10, which is essentially an S&P 500 Index Fund annuity with no fee and a guaranteed premium. The way it works is that every year Allianz selects a monthly gain cap, say 2.8%, and every month your annuity gains up to 2.8% based on the S&P's performance. If at the end of the year your monthly percentage gain adds up to 29% or less, you get the full gains. If your total is negative, you do not lose anything, your principal remains intact, you just don't make any gains. The way Allianz makes money, obviously, is that anything over the 2.8% monthly cap, they keep. Also, they get your principal up front. If you invest for a minimum ten years, they give you a 10% bonus. You get one penalty free withdrawal per year up to 10% of your principal. I am not 100% clear on the implications should my mom pass away before the term is up, and the capital gains/end of term tax implications also seem a little cloudy, so I'm still working through some of that.
posted by spicynuts at 8:37 AM on October 5, 2005

Response by poster: Whoops...that first sentence should read GUARANTEED PRINICIPAL, not premium.
posted by spicynuts at 8:40 AM on October 5, 2005

spicynuts-- if the annuity doesn't have a stated payment schedule, it is a deferred annuity.

Deferred or immediate. It's one or the other.

And this sounds like a bit of a rip, especially given that markets have fat tails-- monthly and yearly returns do, too. You should read that contract very, very closely.
posted by Kwantsar at 12:47 PM on October 5, 2005

Also, it has a 7-year surrender period (can't get all of your money before then without fees), and the gains from the annuity are taxed at normal rates (not 15%!) when they are withdrawn.

Reading more of the specifics, in fact, I gotta say No Fucking Way.

Email's in my profile.
posted by Kwantsar at 12:52 PM on October 5, 2005

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