Annuities have received a lot of bad press recently, and much of it for good reason. Life insurance agents and securities brokers often foist annuities upon their clients without properly explaining them or ensuring that the annuities fit their clients’ needs.
Why? Because annuities typically pay handsome commissions to the salespeople. But does this mean that annuities are always bad? Given the right circumstances, fixed annuities and variable annuities could be the right financial vehicle for you.
What Are Annuities Anyway?
Annuities are life insurance products designed to provide supplemental income, mostly for retired people. The term “annuity” literally means “annual payment of allowance or income.”
Basically, annuities tend to work like this: Someone pays a set monthly premium, as with life insurance, for so many years. Then, when he’s done paying, he waits for a while. A few years later, he begins receiving monthly income.
The amount he is to receive, usually for the rest of his life, is generally much greater than the total amount of premiums he paid in.
Fixed Annuities – The Original Version
Fixed annuities work much like the example above. The key thing is that with fixed annuities, investors are guaranteed a set pay-out. Almost no other investment product guarantees anything, and that’s why fixed annuities are actually a form of insurance, not securities.
The big problem with fixed annuities is inflation. While the money you pay in premiums is generally less than you’re guaranteed to receive, when you adjust for inflation, you might be losing out. This is one of the reason annuities have gotten so much bad press recently.
Variable Annuities – New and Improved?
Variable annuities protect you against inflation risk by investing your premiums more aggressively. The downside? While variable annuities guarantee lifetime income, they do not guarantee how much that income might be. In fact, you could even lose money by investing in variable annuities.
For this reason, many of the more ethical financial advisors recommend that you buy a modest life insurance policy and invest the premiums you save into solid mutual funds.
To Be Fair – The Upside of Annuities
Theoretically, annuities could be a great investment vehicle. Rather than “throwing away” life insurance premiums, annuities can provide for a death benefit while simultaneously allowing your money to grow.
Also, when compared to mutual funds, annuities offer several advantages. For one, the money you invest grows tax deferred. This means that you will not be required to pay income tax on the funds invested into an annuity until you begin withdrawing money.
Secondly, variable annuities do guarantee lifetime income, while theoretically at least, you could lose all of your money invested into mutual funds.
In practice, this is unlikely, but at least with an annuity you will be able to plan for the worst case scenario of a guaranteed lifetime benefit. The worst case scenario for mutual funds is $0.
Mutual Funds and Variable Annuities – A Side-by-Side Comparison
Maximum sales load: Mutual fund, 8.5 percent; variable annuity, no maximum. This means that unethical brokers can charge unsuspecting clients any sales charge that they want.
Pricing: Mutual fund, net asset value (NAV) calculated once per day; variable annuity, unit value calculated once per day. Mutual funds have the major advantage of being liquid – you can buy or sell them any business day of the year. A variable annuity is a life insurance product and is not liquid at all.
Share value: Mutual fund, depends on performance of the fund; variable annuity, depends on the performance of the “separate account,” in which a portion of premiums paid are invested.
Make Sure That Your Financial Advisor is Looking Out for Your Interests
If you feel that your financial advisor is more concerned with her own commission revenue than your financial well-being, head for the door and never look back.
Financial advisors are supposed to be professionals, not cheap salespeople. Like doctors and lawyers, their duty is to those whom they serve, not to the company that employs them or to their own paychecks.
Older individuals are especially susceptible to hotshot young brokers who think they can score a quick buck by unloading a junk product with a big commission.
Your best defense against this is to become as fully educated as you can about each investment product that’s recommended to you, and to find a financial advisor with references from people you know you can trust.
A Few Questions to Ask Your Advisor
If you’re ever dubious of a product your advisor is recommending, be sure to ask him how much commission he receives for selling it. Come right out and ask if he would recommend the product if the commission were half or one-third what it is.
Ask him what are some products that he recommends that do not provide such high commissions. And if you really want to rattle your advisor, ask him what score he received on the Series 7 exam. Ask him to show you his certificate proving his score.
Tell him that you’re considering a variety of advisors, and these are the criteria you’re using to determine which one is right for you. It’s important that he remembers that you are his boss, and that he is to put your interests ahead of his own. That’s what being a professional is all about.
