The bottom line is that a very well-funded marketing machine drives the sale of annuities, and you are the target.
Imagine you were told about an investment that could protect your money, help it grow tax-deferred, and even guarantee you an income for life. Sounds great, right? But what if, after signing up, you found out it was expensive, confusing, and didn’t make nearly as much money as you were led to believe? And then you find out the fast-talking salesman made a substantial commission. That’s the story for many people who buy variable and index annuities. Let’s break down why these “investments” often leave people feeling disappointed and stuck.
High Fees and Charges
One of the biggest problems with variable and index annuities is the high fees. Here are some common types:
- Sales Commissions: Ranging 5% to 8% but sometimes as high as 10%.
- Mortality and Expense (M&E) Fees: This refers to insurance charges that supposedly cover the cost of guarantees, Fees are often 1% to 2%.
- Rider Fees: Optional add-ons, or “riders,” for guaranteed income or loss protection come with additional costs that can add up quickly.
- Surrender Charges: If you decide to take your money out early, there’s a big chance you’ll have to pay a hefty penalty, called a surrender charge. These charges can last for years, sometimes more than a decade, and may be as high as 10% of your balance.
- Expense Ratios: Variable annuities offer investors fund options to invest in mutual funds that carry fees much higher than typical index mutual funds.
- Administrative Fees: These cover the cost of managing the annuity.
Complicated and Confusing
Another issue is how overly complicated these products are. When you invest in a low-cost index mutual fund or ETF, you know exactly what you’re getting. But variable and index annuities come with so many complex features and hidden costs that it’s easy to get lost in the details.
Annuity contracts are often 100 pages long! Even those who read them may not grasp all the terminology. Sadly, this means that investors often don’t realize what they’re signing up for until it’s too late.
Disappointing Returns
When people buy an annuity, they’re expecting to grow their money. But many end up disappointed because these products don’t perform as well as they expect. Here’s why:
- Fees and Costs: These take a big bite out of the return the investor actually receives.
- Caps and Limits: With index annuities, even if the market goes up significantly, your gains are capped. For example, if the market gains 20%, you might only receive 5%.
- Complex Formulas: Companies use formulas to calculate your returns. They might use “participation rates” that reduce your payout. If your participation rate is 70%, for instance, you’ll only receive 70% of the market’s return. To add insult to injury, the return is often only the price appreciation of the market and does not include dividend income which can be a large part of total returns.
Some Real-World Examples
- Early in my career, I worked for a large national company that strongly encouraged selling annuities (it was nearly impossible to meet sales goals without selling annuities). We were encouraged to emphasize only the “positives” (tax deferral and guarantees) while avoiding the downsides. I was even told by a manager to lie about an annuity’s guaranteed rate “because a client could never uncover the true return”. I resigned shortly after.
- Back when I worked in a bank trust department, I managed an account for an elderly client. A salesman from an insurance company encouraged the client to liquidate their portfolio to purchase an annuity. The client had been told the annuity would pay 7% for life. I advised the client it was very unlikely the insurance company could guarantee that return. Still, they loved the idea of a guaranteed return with no market risk. I asked them to request the annuity contract to review. After many hours of painful reading, I realized that the pitch was based on a “distribution yield” of 7%, not an actual return. This yield meant the annuity would return interest plus principal to achieve the promised 7%. In reality, when the client passed away, there was a strong chance their return would be negative, and their heirs would receive nothing. For the client to truly benefit, they’d have to live well beyond typical life expectancy. Once the client realized the true details, they understood that the annuity was a poor investment and that they were being misled.
- Someone recently came into our office with an annuity bought seven years ago. They were concerned that the annuity balance hadn’t grown much. Their statement showed the annuity was tied to the S&P 500. I did some math and found the annuity had grown at just 1.95% annually, while the S&P 500 grew at 11.16% annually. This gap reflects the effects of all the hidden fees and limits buried in annuity contracts. To make matters worse, if the client were to liquidate the annuity before eight years, they’d face significant surrender costs – which would make their total return even lower.
These are just three of the many instances where I’ve seen the ugly side of annuities. With promises of “guaranteed income” and “lifetime income,” these products lure people in. Hearing these promises on the radio always makes my skin crawl, knowing someone out there will fall for the deception.
Final Thoughts
Variable and index annuities might sound like a good idea, but they rarely live up to the hype. High fees, lack of liquidity, confusing features, and low returns make them a poor choice for most people. If you’re considering an annuity, make sure you understand all the fees, limitations, and conditions. And remember, there are usually much better options to help you grow your money and plan for the future without hidden traps.
