Nothing is perfect!
Jimmy Fallon does a funny impersonation of Donald Trump. While interviewing Hilary Clinton (the real one) on his late night show, she asked Donald Trump (played by Jimmy Fallon) where he stands on women’s issues.
His hilarious response:
“I know lots of women. They all have issues. Next question.”
(Also, you need to check out the skit where he impersonates Trump while interviewing the real Donald Trump. Very funny.)
Well, I know lots of annuities. And they all have issues too. Not only that, but all mutual funds have their issues. And all ETF (exchange traded funds) and all stocks and bonds.
Everyone’s got issues.
Which is just another way of saying, “There is no one, single perfect investment.”
Every investment has its pros and cons. And every investment that you put into your portfolio needs to have a purpose. You need to know what the goal of the investment is. What are you trying to accomplish?
Is it a guaranteed level of income? Is it growth potential? Is it asset preservation?
So while I’m talking about some “issues” around annuities in this article, I could just as easily use some other type of financial product to discuss, and I may do so in the future.
The fact is, when used properly, annuities can serve a fantastic purpose in many retirees’ portfolios. They can solve some very important problems that retirees have in their retirement planning.
So here are the Top 5 Annuity Problems, and more importantly how to fix these problems.
Annuity Problem #1: Lack of Knowledge
The first problem isn’t really about the annuity product itself. It is more a lack of knowledge of these products.
And this lack of knowledge isn’t just from the consumer’s end. Many so-called financial advisors are also confused about annuities.
Many don’t understand how these products fit into a retirement plan.
And what happens is they don’t adequately explain them to you the consumer. Sure they may explain how the contract works. But do they give you good advice on how the annuity fits in to your overall plan?
For example, do they explain that the fixed annuity is a way to generate guaranteed income… so that you don’t have as much pressure on your investment portfolio to perform?
Afterall, if you have a higher guaranteed income you are more likely to be able to ride out the dips in your investment portfolio when the stock market is in a slump.
Or do they explain that a fixed annuity is a good way to take some of the market risk off your investment portfolio so that you have less volatility in your overall investment portfolio?
Again, volatility is the enemy of retirees. It is unnerving to watch your lifelong savings gyrate up and down in the market (especially if you no longer have an income coming in from your employer).
Even more so if you have to make withdrawals from a portfolio that is currently depressed. If you need to withdraw funds to supplement your income while your investment portfolio is in a slump, you will have to sell more shares to generate enough income.
This will cause your portfolio to deplete much faster when you sell shares at a depressed price.
Did your financial advisor explain how a fixed annuity used as a portion of your overall retirement savings could help mitigate against this?
Annuity Problem #2: Surrender Charges
Another common “issue” with annuities (whether they be fixed annuities or variable annuities) is that most have surrender charges.
Surrender charges are the charge you would pay if you pull too much money out of your annuity before the contract has matured.
Many variable annuities have 7 year surrender charges. Many fixed index annuities have between 7 and 12 years of surrender charges.
The surrender charges typically decline each year that you hold an annuity. Then the surrender charges completely go away after a certain number of years. For a 7 year contract, the surrender charges go away after 7 years. For a 10 year contract it is 10 years. You get the picture.
Also, I might add, other investments can have something very much like surrender charges too. Some mutual funds have what is known as Contingent Deferred Sales Charges. These act very much like surrender charges.
The simplest way to avoid this annuity problem of surrender charges is to make sure you have sufficient liquidity. That means either cash in the bank or other investments that you can access without an early withdrawal penalty.
This could also include stocks and bonds that you own or cash value in your life insurance policy.
In fact, insurance companies will typically not sell you an annuity unless you go through a suitability questionnaire. The questionnaire will ask you if you have enough liquid assets remaining after purchasing the annuity.
They don’t want you to have to surrender the product and pay surrender charges.
Another way to avoid surrender charges is to take advantage of the 10% penalty free withdrawals. Most annuities will allow you to withdraw 10% penalty free, even when surrender charges are still in effect.
Annuity Problem #3: Interest Rate Risk
One common issue with annuities, especially fixed annuities, is interest rate risk.
Interest rate risk is the risk that you may buy an annuity that guarantees you a specific interest rate, then interest rates in the economy rise while you are locked in for a certain time period at a lower rate.
This causes investors and retirees to miss out on potentially higher interest rates. And this is not just an issue with fixed annuities. The same applies to a CD you buy at a bank. Or even to a bond that you purchase.
The solution that many people have to this risk is to delay buying an annuity. They figure they will wait it out until interest rates rise. Then they will buy an annuity that locks in a higher interest rate.
Well, we’ve been waiting for years for interest rates to rise, and it hasn’t happened yet. For all the people that have been waiting for years until they pull the trigger, if they held that money in a checking account they have missed out on getting some interest rate growth.
And the truth is, once interest rates begin to rise, there will always be the temptation to wait just a little bit longer to get that higher rate. It becomes a timing game. And we all know that timing markets (in this case timing interest rate directions) is typically a loser’s game.
What is a better solution to the very real problem of interest rate risk?
Laddering is done in other investments, like bonds. Instead of putting all your funds into a 10 year contract, spread them out.
Put some in a 3 year annuity, 5 year annuity, 7 year annuity and a 10 year annuity.
When the 3 year annuity matures, you can reinvest it at what will hopefully be higher prevailing interest rates. If the rates aren’t any higher at that time, well at least you got some interest on your money in the mean time. It certainly beats the little to nothing in interest it would have earned in a savings account or checking account.
Using a laddering strategy allows your money to mature periodically. Say, every 3, 5, 7, or 10 years. This allows you to get higher interest rates if rates have gone up.
It also allows you to get some interest income in the meantime without having all your money locked in at historically low rates.
Annuity Problem #4: Annuity Fees
Another issue with many annuities is the fees associated with them.
Typically the annuities with the most fees are variable annuities. Most fixed annuities have no fees, unless of course you add an optional rider to them.
Variable annuities are notorious for having high fees. That is because they are a financial product that gives you the potential benefit from market growth, while at the same time offering some guarantees.
And you have to pay for those guarantees.
Sometimes the cost of a variable annuity can be so high that the potential of market growth is very seriously hampered by the drag of the fees.
To avoid annuity fees you can stick with fixed annuities, and stay away from traditional variable annuities.
But if the guarantees of a variable annuity would help you meet your goals, then try to find one with lower fees. And be sure that you are not paying for any optional riders that are not of much benefit to you. An additional 1% optional rider fee (on top of the other expenses) can add up to a lot of money, especially if it’s of no benefit to you.
Annuity Problem #5: Annuity Complexity
Some annuities can be very complex. Some are very simple to understand.
The simple ones include:
- MYGA’s (Mult-Year Guaranteed Annuities) – These are similar to bank CD’s. They give you a stated interest rate for a stated length of time. Pretty straight forward.
- SPIA’s (Single Premium Immediate Annuities) – With these you pay a single payment and it turns into an income stream. The income stream can last the rest of your life if you want it to.
- DIA’s (Deferred Income Annuities) – These annuities are like SPIA’s. You put in a payment (premium), then defer income from it until later. It then starts an income stream later. A child could understand this it’s so simple.
But some annuities have more complexity. Variable annuities have more complexity. They include a death benefit, they have various sub-accounts to invest in, and they can include a rider. Usually the rider is an income rider, but sometimes it can be a death benefit rider.
There is a necessary level of complexity when it comes to adding these benefits.
Fixed index annuities can be a little complex. But much of their complexity comes from the various different interest crediting methods. The income rider can also add some complexity based on how the payouts are calculated.
When it comes to these issues, here is how you can simplify them.
In today’s interest rate environment, it is reasonable to expect between 3% to 6% in return from a fixed index annuity. The simplest interest crediting methods will give you some growth based on a year-to-year basis of the index.
They will limit your growth with a cap rate (you cannot earn more interest than the cap) or they will limit your growth with a spread (they will deduct a percentage from whatever the index returned).
That’s generally how they work. Sure you can study over the seemingly limitless indexing options that are out there now. Many use the S&P 500 as the index. But there are countless other indexes available.
But remember to keep your expectations in line. Since there is no market risk in a fixed index annuity, don’t expect fantastic growth. You are not going to find that one magical index out there that an insurance company discovered and is now using that will give you phenomenal growth.
It’s not going to happen, so don’t obsess over it. In this current interest rate environment expect between 3% to 6%. That should help keep you from getting bogged down in all the various indexes that are available.
If conservative growth is what you are after, a good place to start is to find an uncapped strategy or at the least a high capped rate. Focus on that first.
Hope that helps you to see some “issues” with annuities and how to overcome these issues. Remember, there is no perfect investment. Everything has a pro and a con.
And every investment in your portfolio needs to have a purpose. Annuities can serve a good purpose in many retirees portfolios if they are used properly and the right ones are picked to solve for your specific problems.
If you know anyone that could benefit from this article dealing with annuity problems, please forward it to them. You can easily share it on Facebook by clicking the Facebook icon on the left of the screen.