Are annuities scam? Do you think Life Insurance Companies invented this complex financial product to take your money and run? I don’t think there is a need to become paranoiac about annuities, they are not a scam. However, it doesn’t mean that annuities don’t have flaws.
#1 You Already Bought an Annuity and You Don’t Even Know
If you believe everybody should buy an annuity, you’ll be happy to know that we all have one. When you think about it, if you have ever worked, you have contributed to Social Security. This “Government pension plan” is nothing but a deferred group annuity. As long as you live as a retiree, you will receive Social Security payments. Unfortunately, those payments are not enough to cover for your yearly drip at the beach and pay for nice restaurants. Let just say it’s not the best annuity you could have bought. You will most likely need to purchase another annuity contract if you want to cover your additional expenses. On the other side, if annuities would be a scam, Government wouldn’t buy one for you.
#2 Forget About Your Money
This is probably the point where most people forget when they purchase an annuity; once you buy an annuity, you “lose” your money. You didn’t get scammed; you will still receive your monthly payment according to the contract you have signed. However, you won’t be able to withdraw important lump sum of money once the money is locked in the annuity. It is important to keep an amount as liquid cash for your emergency as the annuity is not the right product to access your money rapidly.
#3 There are No Free Lunches
The thought of receiving a guaranteed stream of income for the rest of your life is surely appealing. But there are no free lunches in finance and there is a price to pay to enter in an annuity contract. If you select a variable annuity, fees charged through mutual funds are above the market average. Insurance fees, distribution costs along with management fees apply on those contracts. It is not rare they exceed 3%. This is probably where you can call annuities a scam if you don’t do your research probably. There are simple and cheap annuities such as a standard life annuity. The more options and potential return you add to your contract, the higher your fees are going to be.
A good trick to reduce your fees is to buy immediate annuities with no riders (options) and subaccounts (mutual funds with high MERs). If you are comfortable with financial language, you can also purchase your annuity directly with the Life Insurance Company and skip the broker’s commission. However, this is recommended to go through an adviser or a broker if you require further assistance and financial advices. As I’ve written before, there are no free lunches: if you seek for quality advices, you will have to pay for them.
#4 Tax Deferment Doesn’t Rhyme with Tax Disappearing
Deferred annuities offer the possibility of your investment to grow tax free… or this is how it can be presented by some agents. It is true that the investment profit while the annuity grows is not taxable. This only means that you will not be taxed as long as you don’t start withdrawing from your annuity. Once the annuity starts to pays, your payment are subject to taxes. Depending if you annuity is qualified or not (read qualified vs non-qualified annuities to know the difference), the annuity payment could be a 100% taxable revenues subject to the same tax rate of any other income. Then again, annuity payments are not part of a big scam, it’s only a matter of understanding that annuities offer tax deferment but you will still have to pay taxes one day. If you don’t, this means that you will pass your taxes to be paid to your estate at your death.
#5 Annuities are Complex to Explain
If you are searching for the annuity formula, you will be disappointed. Basically, only the actuaries working for the Life Insurance Company knows about the magic formula. The worst part is that they can change the way they calculate the payment from an annuity from month to month.
If you seek for an annuity in exchange of an investment of $200,000, you may want to deal with a broker or call different life insurance company yourself. Each company has their own metrics based on life expectancy assumption, interest rate and market return potential along with managing their own book of annuities. If a Life Insurance Company sold too many annuities to 65 years old this month, they might decrease their annuity payment offered for next quotes to discourage investor from buying. Those actions are necessary to manage the overall risk of the annuity portfolio.
When you purchase an annuity, you agree to put your money in a black box form which you receive an income stream. Payments are guaranteed as per your contract but the way it is calculated is extremely difficult if not impossible to understand.
Your best bet is to contact a broker that will shop around to find the highest paying annuity for you. You can contact a trusted broker to get the best rate here.
#6 There are More Riders than You Can Count
Several kinds of riders are offered for all annuity contracts. A rider is an option you can add to your contract in order to customize your annuity. As you can imagine, the more you customize your product, the more expensive it becomes. You can add riders to improve your annuity payments, add a beneficiary, add extra withdrawals payments, etc. The more riders you add, the more flexible your annuity becomes. But there is a price to pay for each rider.
Ask for different simulations and compare them to the original annuity with no riders in order to understand how much you pay for each added option.
As you can see, annuities are no scam but they are fairly complex. There are very useful and cheap annuities but there is also very expensive one with unnecessary riders. It’s up to you to ask questions and wait patiently for complete answers. If you can’t get a clear answer to your question, this is a good sign you need to change adviser or you may scream for an annuity scam!