The regular ups and downs of the stock market are a thrill ride many people don’t want to take. We want some assurance that our hard-earned money won’t disappear in a market downturn. That’s the very moment that the annuity sharks start to circle.

In an effort to keep ourselves safe and secure, we become attracted to phrases like “guaranteed withdrawals,” “minimum returns,” and “guaranteed interest rates.” Annuities seem to take the risk out of saving money and investing.

Except that they don’t. Annuities don’t always provide the “safety” that we are seeking. They have high costs that are hidden in confusing contract language. There have restrictions on withdrawals that cost you just to get access to your money. The broker may convince us that annuities aren’t risky. Actually, annuities have some “guaranteed risks.”

All annuity contracts are different, but here’s one scenario. A woman is approached by her broker, also an insurance salesman, who suggests that she liquidate all holdings in her $400,000 IRA to purchase an annuity. She is sold a “single premium deferred annuity.” She paid only one premium (the proceeds from her IRA), and the maturity of the annuity is deferred until a later date, called the Income Date.

The Annuity Details

The annuity guarantees her a one percent annual rate of return. As a bonus, the policy gives her a two percent rate of return during the second year of the policy.

There is a surrender fee for the first seven years of the policy. She cannot withdraw funds during that time without paying a penalty. In the first three years, the surrender fee is seven percent of the amount withdrawn. Ouch! In the next four years, it steps down gradually to four percent. In the eighth year, there is no withdrawal fee.

There is a ten percent limit on withdrawals before the Income Date. The ten percent limit applies to the current value of the policy. If she withdraws ten percent in one year, the next year she can withdraw fewer dollars. If she withdrew ten percent in the first year ($40,000), the remaining value will be approximately $357,000, meaning the second year she may only withdraw $35,700.

Finally, the Income Date is 30 years from the date of inception.

The Guaranteed Risks of Annuities

Already I’ve identified two significant risks. The first is the inflation risk of the so-called guaranteed rate of return, a whopping one percent! Inflation averages nearly three percent annually. The annuity contract guarantees the policy holder will lose purchasing power more and more as the years go by. This is a terrible strategy for a long-term investment. The surrender fee and ten percent withdrawal limit, however, guarantee that this will be a long-term investment.

The second risk is liquidity. The policy has built in mechanisms to keep the her hands off the assets. A hefty surrender fee hedges the insurance company against buyer’s remorse. The policy holder will certainly have remorse when she realizes she can’t access her money. The ten percent limit and 30-year Income Date conspire to keep the money in the hands of the insurance company. If, in the third year of the policy, she has an emergency, she may withdraw $40,000 (the ten percent limit) and pay a hefty $2,800 surrender fee to do so.

If your broker suggests that you purchase an annuity, step back and get a second opinion. Ask questions like:

  • Do I understand the contract?
  • What kinds of expenses, restrictions and limits are associated with the annuity?
  • Will I be charged if I withdraw assets early?
  • What impact will inflation have on my annuity income?
  • What are the tax consequences of making this move?
  • How will the annuity and income be taxed?
  • Are there better investment options available to me?

Perhaps the best question is, why does my broker want me to purchase this annuity? Remember, there’s no such thing as a free lunch – brokers are not required to put your interests ahead of their own at any time.

Seek the advice of a Registered Investment Advisor, such as Endress Capital Management. We put your money to work for you, and are always on your side.