How Annuities are Priced: Costs, Fees, Charges and Commissions
Once upon a time, annuities were fairly simple products, on which the insurance company sought to make money on the interest rate spread between what it earned on bond-like investments, and the interest it paid out on life insurance contracts like annuity policies. In this way, business was a very bank-like proposition—and at least one author referred to insurance companies as the “the invisible bankers” —with the twist of having to manages life expectancy risk along with interest rates. These days, contracts and opportunities for insurance company profits, have gotten a lot more complicated. Besides the spread, contracts can be loaded with a lot of other expensive features and riders from guaranteed income, refund, death benefit, market high water mark to investment reallocation and timing change privilege features.
These can be on top of the administrative, mortality, sub account (“mutual fund”), premium tax, and other charges found in popular variable annuity products. In many cases, total costs are astonishingly high, “hidden” in many different documents, and hard for consumers to figure out and put together. It can often be best to ask a knowledgeable advisor to examine a policy and report on total costs to save you effort or to make sure you catch everything. This is something Camarda does often at no cost as part of its free portfolio stress test offer. One rule of thumb, however, seems pretty accurate and is quite simple: you can usually infer the commission of the sales team pitching the annuity, and it is often close to the same percentage as the first year surrender charge. If the first year cost to get your money back is 8%—and it gets way worse than this—odds are good the agent team made the same. That’s some $80,000 per million in annuity premium, folks, which is pretty much a transaction fee without any real promise of ongoing service or investment management.
Immediate annuities are annuities in their purest form. With them, the buyer irrevocably, which means you can never change your mind and undo the contract, converts principal into income paid monthly, quarterly, or annually—which are the most common intervals—or every blue moon, for a specified term. The term can be for a period of years, and a good way to think of these annuities is like mortgages in reverse: instead of borrowing a sum and paying it back, with interest, over so much time, you give—actually lend—a sum of money in exchange for payments with interest until the contract has been repaid. The payback term can be very straightforward, like for twenty years, and at the end the entire sum has been returned at the contracted rate of interest.
This simple type of annuity is called for a period certain, and the insurance company makes money by paying you a rate of interest lower than it expects to be able to earn on the money it invests. This is very similar to how a bank makes its money, on the spread between what it earns, and the lower amount it pays depositors.
Buyers, take note: in the ultra-low interest rate environment of the post Great Recession world, in many cases, annuity payments may be calculated such that you barely get principal back with little or no interest, and it is possible that you get back less than you put in. There are many, many moving parts, and this is an oversimplification, but it is entirely possible to contract to receive lifetime payments that add up to less than you put in—sort of a negative interest effect.
But annuities, being life insurance contracts, are subject to the dark art of actuarial science, the cold equations of money and death, and most annuities are based on payouts figured on the life expectancy of the annuitant.
With enough lives in the pot, an actuary can pretty precisely calculate the average payout period—based on the average life expectancy of annuitants—and price annuity interest payout rates such that the insurance company is very likely to make money.
A pure life annuity pays for only so long as the annuitant shall life. Annuity payments continue only so long as the annuitant is alive. If we assume an average life expectantly of twenty years for a given age class, the insurance company really makes out on those that die sooner, and gets hurt on those that outlive the life expectancy. This latter point (the ability to contract for income lasting longer than life expectancy if you live a long time) is a key benefit of annuities that nothing else (except a pension which is really an annuity) will do. There will be more on these so- called longevity credits later.
Of course, as in Vegas, the insurance companies don’t ever expect to actually get hurt. So long as they have enough players, the laws of averages come into play, and the house will always win, since it is the one who gets to set the odds, provided it is smart enough to set them right.
Let’s look at an example from the good old days when the word “interest” actually meant something. Say we assume an average life expectancy of 20 years, and a $100,000 annuity premium to be annuitized into income. Also say that prevailing investable interest rates—like on high-grade corporate bonds, mortgages, and long- term government bonds—average 8%, and the insurance company can invest annuity premiums at that rate. Investing $100K at 8% for twenty years will pay $836/month for twenty years, after which—just like a mortgage in reverse—the principal will have been repaid with interest, and the payments will cease. If the insurance company sets its annuity payout rate at 5%, the annuity will actually pay $660 a month, leaving a spread profit for the insurance company of something like $176/mo. This will translate into a profit of $104,000 for the insurance company at the end of the 20 years, before expenses. This is the same thing as saying that $176 invested each month—the “extra” earnings on the annuity premium that the insurance company keeps—will grow to be about $104K after 20 years at 8%.
The blissfully ignorant annuity payout recipient will get $660 a month. If he (men have shorter life expectancies) dies sooner than 20 years, the insurance company pockets the unpaid balance. If she outlives the 20 years, the company will have to keep paying out of its profits until she dies.
To put things in modern context, the payment would be $417 a month over 20 years with a zero interest rate.
But those that say, “The annuity owner bets they will outlive their life expectancy, and the insurance company bets they will die sooner,” really miss the point. Insurance companies endeavor to predict with cold accuracy how long the average annuitant will live and build in a healthy margin to make sure they make money. And the trick is really in the interest rate used to figure the annuity payments: the lower it is, the lower the payment, and the more profitable the product for the company. Back in the 1990s as a life agent selling these kinds of products, I was constantly amazed at the difference in offered payouts for the same person for the same premium. Given (we presume) the same assumed life expectancy, and the same premium dollars offered, the monthly payout quotes varied widely. The only difference was in the interest rate used to figure the payout . . . and the profit for the insurance company.
Once you get a feel for this sort of black art, all kinds of payout periods come to mind. Joint and survivor means we will pay until the last of two people die, and, of course, given their sexes and ages, we can figure a joint life expectancy on which to base the payout period. Joint and one-half survivor? No problem! We’ll figure full payout for his life expectancy, then mix in a payment cut in half for the balance of her life expectancy after he dies. Refund annuity (where they’ll pay out the “unpaid” balance of the unpaid initial premium in case he dies before getting all of his initial outlay back at his death)? Piece of cake. Since the insurance company can easily compute the average payout term in any such scenario, making money is easy, since it can always figure a payout level less than what it will make on the money paid in via immediate annuity premium, provided it gets average life expectancy right.
Of course, it goes without saying that the layperson is helpless at trying to duplicate the math and evaluating just what a “fair” payout level might be. Too many folks think that “getting the money back” (breaking even) after so many years is a fair proposition. Remember that getting $5K a year for 20 years is breaking even, but that at even 6% the really fair annual payment is over $8,700, a 74% difference. And that most of us can—and should—shoot for far more than 6% over a 20-year income Period—even with the low interest rates of the early 21 st century. 8% bumps the annual payment to $10,200, more than twice break even.10% brings it to almost $12K annually. But for those with the right training and the right computers, making money by pricing annuities for insurance companies is as easy as setting up the slot machines in a casino.
This payment amount, by the way, can be based on the interest rate prevailing at the time of annuitization (best to shop, these rates vary from company to company even on the same day), in which case we have a fixed immediate annuity whose regular payment amount does not change from the initial schedule. While the schedule can incorporate future changes triggered by events like inflation or the death of an annuitant, the payment itself is determined by the interest rate at annuitization. Variable immediate annuities, on the other hand, have payments whose amounts vary based on the performance of securities markets, like stock indices. These can be complicated beyond the belief of the layperson, and turn out to be real shockers for those on fixed incomes when the markets drop.
Immediate vs. Deferred Annuities
The first basic distinction among annuities contracts is between immediate vs. deferred. As you may have read elsewhere, all annuities are designed to be irrevocably converted into income at some point, by definition. This really goes to the core of what annuities are. We might even say that deferred annuities (those that appear designed to grow like bank or investment accounts and offer some access to our principal) are simply waiting to grow up into immediate annuities, at which point our claim on principal goes poof, and we have only a stream of periodic checks where once was a mighty pool of liquidity. Once again, by contract and by design, a deferred annuity is an immediate annuity waiting to happen.
You MUST forever bear in mind that annuities are designed to ultimately convert liquid principal into income according to some contractual scheme. This is a fundamental characteristic of what annuities are. We’ll get into a bit more detail elsewhere in this section, so keep reading!
Pensionizing assets – annuities for retirement income
Annuities, like pensions and Social Security, offer the promise of lifetime income, something no other investment class can do. With stocks, bonds, real estate, and other alternatives, income that one cannot outlive is a risk-based probability (and a hard one to figure accurately), not a certainty. With annuities, so long as the insurance company stays in business and honors its promises, lifetime income is guaranteed. This is why lotteries and pensions often turn to annuities for funding, and it is an extremely powerful proposition. We explored earlier in this paper the various ways that annuity payouts can be figured based on single and multiple life expectancies, and contractual provisions like variable, equity index, and guaranteed withdrawal benefit rider accounts can complicate the income math and opportunity/risk permutations quite a bit.
This lifetime income feature is so important that in many cases it counterbalances and even overcomes the many shortcomings that particular annuities may be saddled with, including high costs, high taxation, illiquidity, and others. For those whose asset levels are such that the ability to ensure lifetime income is uncertain—true for many but not all consumers—annuities should be seriously considered to fill the income gap, especially for those whose only true pension is Social Security, or for whom pension income is comfortable only so long as both spouses are living. For many, converting some assets to lifetime income—which I call pensionizing—is an important strategy, which should merit serious consideration and analysis. Unfortunately, this analysis (how much asset value to convert, what income deficit must be funded for, and when, and which annuity products offer the lowest costs, best value and most applicable features for a given consumer’s needs) can be extremely complicated, and is probably best not left to a given commission salesperson’s advice.
Reasons to consider getting out of annuities you may have Annuity Interventions – Reasons and Strategies
As mentioned, sometimes annuities are perfectly appropriate, fairly priced, and important components of sound retirement strategies.
All too often—and most of the time in my professional experience—annuities are improperly sold and poor choices for many investors. They can increase taxes over comparable non-annuity investments, reducing net wealth. Costs often run much higher than other portfolio options, also reducing wealth. Both tax and internal costs are typically hard to spot, and investors may not know what is happening to them. Frequently expensive riders are layered onto policies, greatly increasing costs—and agent commissions in many cases!—to sometimes unbelievable levels. While riders can provide valuable income features, in many cases they are not great matches for client needs or goals, cutting growth for no good reason. For instance, I recently met a doctor who had sufficient pension income and did not need income from annuities, but had most of his money in them with expensive income riders. Since his main wealth goal was to pass money on to his son, the riders worked at cross-purposes for him. Worse, income and estate tax treatment differences over alternate investment like stocks or mutual funds will result in a big chunk of potential inheritance needlessly going to taxes instead.
There are a lot of good reasons to own annuities, but at least just as many to not own them, or to own more appropriate or less expensive ones.
Assuming it makes sense to get out, qualified annuities (those in things like IRA’s or 401ks) can be surrendered (the term for cashing in a life insurance product) without fear of tax impact. Provided the product was a poor choice and the surrender charges are not onerous, you may wish to consider other products like mutual funds or individual stocks or bonds. Even when surrender charges are high, it pays to get a detailed examination of total product costs. With some products costing in the 5% range each year just for the privilege of owning them, it may not take long to recover even a 10% range surrender charge, and your ultimate wealth may be much higher taking the hit to reap lower ongoing costs and, perhaps, better investment management and performance. As mentioned above, actually discovering all the “hidden” costs in multiple documents is sometimes a challenge, and the skeptical may wonder if this is a coincidence. It may be helpful to have a professional review by someone who deeply understands these matters, to help ferret out the many potential costs and put them in context for you. My firm—Camarda Wealth Advisory Group—offers this service for free as part of our Portfolio Stress Test program, and you can call us at 1-888- CAMARDA if you want one.
For non-qualified annuities (those not in IRAs and qualified plans), tax treatment is a little trickier. For those who actually have losses—far too many in my experience—you have the opportunity to write off an ordinary loss, which is much more valuable in most cases than the more common capital loss. In some cases, nearly twice as valuable, even before you consider the time value of money (capital losses by themselves are not meaningfully deductible unless you have offsetting capital gains, but ordinary losses come off your other income, right now, at your highest marginal bracket). If you have us do the Portfolio Stress Test, we can help you determine your tax opportunities, or exposure. For those with significant gains in annuities, there are two basic strategies: 1035 exchanges and what I call tax bracket arbitrage. 1035s let you “rollover” an annuity like an IRA, deferring any tax until you actually take money out. As mentioned about, a lot of low-cost, high quality, and no-commission products have emerged that make destinations for money from expensive annuities. 1035s are painless, but one must remember that annuities carry perhaps the highest potential tax rate of all investments. So, deferring more gains to ultimately just pay more tax may not be the best plan. Tax arbitrage, which is not unique to annuities, just means pulling as much money out in low brackets as you can. Take a look at the tax table below, courtesy of the IRS for the 2016 tax year.
Beyond mentioning that this is taxable, not gross, income, we won’t get into the quagmire of tax math here, but note that the complexity of the tax code offers much opportunity for tax savings and wealth building to those with advisors who actually understand it well, which, unfortunately, can often be a minority! It does not take a rocket scientist, however, to note that it is better to pay a 10% rate than a 40% (39.6%, actually). The first nets $9000 on $10000, the second only $6000, a lot less. So the essence of this “arbitrage” is simply not taking taxable distributions from annuities (or IRAs or other similar discretionary vehicles) during high bracket years. Admittedly, this takes a bit of sharp, proactive planning—not so easy if you have a typical tax advisor/preparer who does works hard to save you tax and does not practice active strategy on the fly—but it’s not really complicated to do. Believe it or not, your bracket changes more than you may believe year to year, and your decisions can have more power and impact than you may imagine.
One final word on surrender charges: while many annuity sales are proper and well disclosed, far too many are not. If you believe the sale agent did not fully disclose risks, charges, surrender charges, or other material items, you should probably consider a complaint to the insurance carrier who issues the annuity and to your state insurance commission if you need to. There has been enough abuse—particularly in the senior market—that the companies and regulators are very sensitive to this. There is a good chance that you may get surrender charges back and other concessions if the sale was not pure, but only if you squawk enough.
Red money, green money, and annuities
For those that use them, annuities should really only be considered as part of a retirement income plan and, then shopped very carefully with an eye toward features and costs. Those with sufficient assets or income from pensions, businesses, rental properties, or other sources likely do not need them at all. As pure investments apart from the income feature for which annuities were designed, annuities are generally a poor choice, given high, typical costs, commissions, and rather oppressive tax treatment both at the income and estate tax levels. This is even true after considering the guarantees of equity index annuities with principal protection and stock market participation. Unless you really need income, you will almost certainly make more money over the long haul by just leaving money invested in a stocks or mutual funds program—riding the ups and downs—than in a guaranteed annuity. In fact, the insurance company is counting on that, which is one of the reasons they can offer guarantees and still make a profit (by buying a guaranteed annuity, you transfer some or most of the long-term profit potential of the stock market to them).
That said, for those who have a retirement income gap (guaranteed income sources like pensions and Social Security do not add up to enough to fund a floor or minimum acceptable lifestyle), the Money Color concept could be a useful rule of thumb to help think about the issue and guide decisions. In this concept, “green money” represents guaranteed income sources like pensions, “yellow money” represents cash and cash equivalents like bank accounts and safe, short-term bonds, and “red money” represents risk capital, like stocks, subject to market fluctuations and changes in value. Here’s the premise: put enough into green money to fund for a minimum acceptable lifestyle, deploying capital income annuities if needed to bring the level of guaranteed payments up to match floor expenses. Keep enough in yellow money for emergencies and lifestyle splurges— within affordable reason. Put the rest into a sound red money investment program—which is the engine that offers the greatest potential for wealth growth— knowing you can comfortably ride out the inevitable swings since your needs are covered by green money. Of course, this is a very gross simplification of an extremely complex problem, but it is very useful in offering a mental map to crystallize the problem and guide sound decisions. This can really help people avoid bad knee jerk decisions or deer-in- headlights inaction.
Taxes on annuities – higher than other investments
Annuities are taxed kind of as a hybrid between “qualified” retirement plans and IRAs and regular taxable investments. For annuities inside such plans like IRAs, 401ks, TSA/403bs, etc., the IRA tax treatment controls, and the entire value of the annuity—initial investment and all the growth—will be taxed as ordinary income in the year you take it out, which means you will pay your highest tax bracket on the distributions. In other words, they are treated just like any other investment in such an IRA for tax purposes. The same is generally true for ROTHs —tax-free treatment once the ROTH criteria have been satisfied—but check with your tax advisor to be sure.
Annuities outside of retirement plans—so-called “non-qualified” annuities, those you buy with after tax money— “enjoy” their own rather quirky tax treatment, which can prove rather oppressive. For one thing, the tax treatment is ordinary income (again, read your highest marginal tax rate), which can be double the rate on capital gains, generally applied to stocks and much mutual funds growth. This is worth underscoring: annuities’ growth is generally taxed at up to double the rates on other types of investments. This can be a real damper on the wealth value for consumers who can only consume what’s left after taxes. And while the gains on non-qualified annuities are deferred (which means you don’t pay tax until you actually pull money out of the contract) the same sort of 10% penalty as for IRAs applies to pre-59 ½ distributions. In that case, you pay your highest marginal tax rate (and the distribution can easily put you into a higher bracket), plus 10% of the taxable distribution. This is quite different from capital gains treatment on things like stocks, which are also deferred until you choose to recognize the gain, and come with no pre 59 ½ 10% additional excise penalty, besides having a top tax rate about half of the top ordinary income tax rate. Finally, annuities are subject to last-in- last-out (“LIFO”) rules, which mean you have to pay the tax on all of the gain before getting your initial investment back tax-free. This treatment can bunch taxable events, accelerate taxation, and drive higher rates, all of which can reduce the amount left for you and your family. This is also quite different than the rules for capital gains, which can be much more flexible in letting you and your tax advisor pick your tax shots, reducing tax recognition and better controlling rates to yield more for you.
In many ways, non-qualified annuities are saddled with some of the worst tax rules for investors, and this should give many investors pause.
On the other hand, losses on annuities are “ordinary losses” and can be deducted against other sources of income, like wages, without limit—a big advantage over capital losses. Those who are down should consider the wisdom of this exit ramp, especially during down market cycles where this applies. This can be a big value tax strategy for those “stuck” in annuities. Finally, those with gains should consider “1035” (the number refers to an Internal Revenue Code section permitting this technique) exchanges, which allow tax-deferred “rollovers” between annuities. This can be a big help in getting out of expensive, poorly-managed annuities and into low-cost, no-load products while avoiding current taxation.
Good Sales, Bad Sales: Duties and Disclosure
This leads nicely into the next reason why annuities can be easy to sell for those more interested in high commissions than in providing high value to investors: threadbare disclosure of material facts, like commission levels, surrender charges, costs and fees, risk levels, taxation, and the other factors that bear on a prudent, well-reasoned decision. Not that annuities are unique in this. Variable annuities share with most investments are securities (and so regulated by the Securities Exchange Commission, or SEC) minimum and require disclosure, which is so obtuse and scattered as to be invisible in plain sight to most people. The tale is the same for mutual funds, “managed money,” wrap accounts, and other “packaged” investments as well, and are only some of the many, many ways the financial industry dips its collective beak deeply into the pocket of the investing public with nary a trace or a thank you. But the required disclosure for fixed annuities (those regulated only by the individual states’ insurance commissions, since the life insurance industry lacks any Federal oversight) has been virtually non-existent, and still has a long way to go to be obvious to most consumers. Matters in this regard have been so bad that the companies themselves, in order to gird themselves against future litigation for misleading product sales, often impose more in the way of disclosure than the states require! Of course, it still has a marketing spin, and is usually in no way adequate to communicate the material facts to the person of average financial knowledge. Please note that equity index annuities (those that offer stock market based returns but guarantee return of principal) are fixed products beyond the reach of SEC disclosure. This has been a major product growth areas, and chances are strong you’ve been pitched one of these, especially after the market meltdown of 2008, and with the 2015/16 corrections. These are the kind that say something like “if the market goes up you make money, but if it goes down, your principle is guaranteed!” In reality, index annuities are complicated derivatives products, but they are not invested in stocks or other securities, and, hence, beyond the reach of the SEC—they are regulated by the States as the life insurance policies they really are.
The fact that annuity commissions lack mutual fund-style breakpoints (where the percentage commission goes down as the dollar amount goes up, giving a volume discount, as it were) makes very large dollar commissions possible. Fifteen percent on a million dollar sale—and sales of this magnitude occur every day—means a $150,000 payday for one sale. Eight percent—a more typical payout, perhaps, stills nets the salesperson $80,000. Fast. Breakpoints have been a staple of the mutual funds industry for decades. Even a “fair” commission of 7% nets $70K—not bad for a few hours’ work!
Two more points, and I’m sure we will have convinced you to go out and sell annuities yourself, for profit and profit. Commissions are typically paid quickly, in many cases weekly, as soon as the investor’s check is cashed, and any state-required rescission period—the ten to thirty day “free look” has passed. So the money is quick, as well as big. And, finally, insurance agents, planners, and other salespeople who know the ropes can make tons more selling annuities than other investment products like mutual funds, since they generally get to keep the entire commission, instead of being forced to split it with their “broker/dealer” or sponsoring securities sales company. And many even seem to make a habit of finding “better” annuities every few years, and recycling investors’ money in what can look like a perpetual commission machine.
The “Annuity Wars”
Welcome to one of the most confusing and hotly debated topics in the financial world. Our objective is to help clear the smoke and give you simple guidelines to help make smarter decisions about one of the most promising—but also potentially one of the most dangerous, expensive, and hard to get out of—financial choices out there.
Annuities are probably one of the most poorly understood—and most polarizing—“investment” types around. It seems like most financial professionals either love them or hate them. Certainly, financial salespeople can love them for the high, hard-to- spot commissions many of them pay. Some media pundits, “consumer advocates” and other advisors can hate them because of the very high internal costs, access fees, and high potential taxes. But everyone has an agenda.
Ken Fisher—who runs one of the largest investment advisories in the country—“hates” annuities, says annuity salespeople “lie,” compares them to Ponzi schemes, and even says some should be illegal.
Others, like “father of financial planning” Harold Evensky (also an advisor and Professor of Financial Planning at Texas Tech), were past opponents, but have come to embrace the “right” annuities as products have evolved and consumers’ needs have changed. In 2015, he even said, “The immediate annuity will be the single most important investment vehicle of the next 10 years.”
Other academics strongly disagree with Fisher’s position. York University professor, Moshe Milevsky, says, “There is a magical, secret ingredient, a secret sauce, inside an annuity that can’t be replicated by other retirement products,” and said some of Fisher’s comments were “blatantly wrong.” Dr. Michael Finke said that the annuities Fisher most hates “ . . . could serve as an ideal default for most Americans rolling their defined contribution assets into an IRA. A competitively priced variable annuity product is hard to beat compared to an unprotected investment portfolio.” Dr. Wade Pfau—a Princeton Economics PhD and a professor in the American College’s PhD program in Financial and Retirement Planning—said, “This is a very important retirement tool. It’s very straightforward: a simple lump-sum payment, and you get income for life. It pools longevity risk across a large [group] of individuals; and because of its mortality credits, those who don’t live long subsidize those who live longer. The mortality credits are part of a [retiree’s] spending power. An income annuity can help preserve the remaining portfolio when someone lives a long time in retirement.” Pfau also said Fisher “is trying to act like he’s doing his clients a service by paying their annuity surrender fees when he’s really just taking it out of the investment management fees he collects,” implying Fisher’s position may be as much about marketing as what’s best for consumers. Milevsky added, “There is almost a consensus in the ‘ivory tower’ that annuities make sense for the consumer . . . there have been 2,000 articles about annuities written by card-carrying professors since the 1960s, and 99.9% of them are pro-annuities.”
But popular commentator, Suze Orman, doesn’t like them, and Forbes even ran an article called “The Great Annuity Rip-Off.”
So who’s right? Like Evensky—whom I know and have worked with on some research ideas—I’ve had a change of heart about annuities over the years. I once ran ads headlined “Got Annuities? The Dirty Secrets Your Agent Never Told You . . .” but with my continuing studies over the past decade, I come to have a more balanced perspective.
The confusing truth is that both points of view are “right.”
There are many horrible things about some annuities, and there are wonderful things about others. The right annuities—and getting it right is of huge importance—can do great thinks for you that nothing else in with world will—if you need these things done!
As with most things, the truth is somewhere in between various positions, and very much depends on your personal needs. Unfortunately, since annuities are so varied and complex, the “in between” part covers a lot of ground, and it’s easy to get lost. We’ll try to narrow it down for you, and help you understand the good, know how to spot the bad, and, most importantly, learn what is best for you.
The long term care elephant
There’s been lots of discussion about long term care in recent years, and for good reason, as this is a very important and expensive issue especially when we consider the possibility that you will live a long time. You should review your own needs in this regard, but my emphasis here is not your care, but on your spouse’s needs. Here are the facts: as long as Medicare lasts in its current guise, it will pay for decent long term care for those who need it. But the catch is that “needing it” means that your joint assets have been spent down to the poverty level. That means that you – and only you – are responsible for the costs of your spouse’s care until the money’s nearly gone. That could leave you without adequate funds to support yourself, and could even push you toward the poverty line, whether you need care or not. Take note: existing Medicaid laws require most couples’ assets to be completely drained before paying for long term care. Given the current debt issues in the United States, it is likely these laws will get even tougher. Fortunately, you can deal with this issue by using insurance and some more advanced estate planning techniques. The time to plan is now, before the dice break the wrong way and before your retirement dreams are potentially shattered.
The whole truth about annuities
Annuities are one of the most controversial financial products around. These life insurance variants have been the nexus of some of the most oppressive hidden fees and commissions, and some of the most abusive sales practices, but are also the foundation of “pensionized” retirement income that cannot be outlived. As with mutual funds, annuity products can range from very inexpensive/high value no-load policies, to extremely expensive, high-commission, poor value types that enrich salespeople while corroding your wealth. Due to confusing disclosure regulations (and, frankly, some unscrupulous salespeople who may not tell all they should) it is difficult for consumers to get a true picture of costs and benefits and make accurate comparisons. Because of this complexity, and possible intentional obfuscation, it is usually best for consumers to get an expert opinion from professions who have deeply studied these specialize life insurance contracts ( click on this site’s front page offer for our free annuities report to get more information on how to get such an opinion). Many investors mistrust all annuities for this reason, which is unfortunate, since academic studies are increasingly showing the importance of annuities in actually increasing total lifetime retirement income. These studies show that in the right circumstances and with the right prescription, the proper annuities can enhance retirement outcomes across the board, from boosting and lengthening income, to increasing inheritances and reserve funds. Depending on the fact pattern, these may include nominal immediate annuities, inflation- protected immediate annuities, GMWB (Guaranteed Minimum Withdrawal Benefit) annuities, and others. There are many caveats, however, including the risk of locking into annuity payments during times of low interest rates, as well as avoiding expensive product with high, hidden commissions.
The non-fixed flavor of deferred annuity (though remember that that immediate annuities can also be “variable” because the payment is based on securities) is called variable, from the fact that your value (payment in the case of an immediate annuity) can vary based on the performance of securities markets. In other words, your account will be worth more or less depending on the stock and bond markets.
These products are often called “mutual funds in an insurance wrapper,” and I think that description is a good one. Unfortunately, in many products, the funds tend to be overpriced and insurance and other costs can get layered on sending total fees to untenable levels. Often, these fees are for unneeded—and sometimes grossly overpriced—features. On the other hand, extremely low cost no-load variable annuity product is available, often favored by those who prefer fee-only advisors.
Variable contracts are usually so convoluted and complex that many owners never really understand precisely what they have. Here are the salient points: unlike for EIAs the risks of gain or loss are as great as when dealing with most any mutual fund family, and will be influenced by your ability—make no mistake, this is your responsibility, not the salesperson’s—to select and maintain funds and investment asset classes which minimize risk and maximize gains. As many investors sadly learned during the Great Crash of 2008, this is no small feat. But proper investment management is another subject entirely.
As with fixed annuities, the insurance company is looking to make money on your money. With fixed annuities, they earn a banker’s spread—invest your money at x% and pay you x% -y%, with y being their profit. With variable annuities, there are two distinct profit mechanisms: the mutual fund fee markup, and the life insurance cost, which they call the mortality cost. All mutual funds charge a percentage of investors’ account value to pay bills and make money for the fund. These percentages tend to be much higher in variable annuities (where the mutual funds are called “sub-accounts”) than in fairly-priced mutual funds. Insurance companies often profit by either putting their own expensive funds in their annuities, or by offering funds from other (usually big- name) mutual fund companies, then jacking up the mutual fund fees. Charging 1-2% annually for the mutual fund fee is by no means unusual, and this is before the insurance cost. These fees—both for mutual funds and variable annuity sub accounts—are never accounted for on any statement. You have to dig in the prospectus—and sometimes in a prospectus supplement too—to find out what they are. But trust me, they’re in there.
The mortality—read life insurance—cost is included because annuities, being dim life insurance contracts, guarantee that at least the value of your initial investment will be paid to your named beneficiaries at your death. So you have insurance, equal to your premium payments minus current annuity value, if you happen to die at a time when your annuity is worth less than you paid for it. Lately, the insurance companies have gotten very creative at offering additional insurance features via riders at substantial, additional costs. But this is the basic premise. Like the mutual fund fees, these insurance charges are never accounted for; so, most people don’t realize they exist.
A mortality charge of 1.25% is very typical, and would equate to $6,250 per year in insurance charges on a $500,000 annuity. Remember that the amount of insurance is only the difference between the total investment and the value on the date of death; much of the time, there may be no real insurance at all. For instance, if we invest $500K and the annuity suffers a huge drop to $400K AND WE DIE, there is $100K of insurance. Whenever the value is equal to or greater than $500K—and the longer we own it before dying, the greater the odds that the value will be greater than what we put in—there is no insurance.
Of course, those mortality charges keep coming out.
In this example,$6,250 a year.
Contrast that with the going rate for term insurance: a healthy person of age 66 could buy $100K of insurance for something like $400 a year, with no rate increase for 10 years. He or she could die at leisure—market up, market down, no matter—and still receive a death benefit. In fact, they could buy over $1.5 million of such insurance, and still not pay as much as the hidden mortality charges in the annuity example above.
So on variable annuities, the insurance company makes money—without any investment risk, I might add—in two principle ways: mutual fund fees and insurance charges. Two percent a year is probably a fair average estimate and not too far off the estimated “banker’s spread” they make on fixed annuities.
And lest you think 2% is trivial, know that on a $500K investment, 2% more is 100K more in 10 years, and $250K more in 20 years. And 2% less via extra fees means so much less, as well.
Bad as this is, many “full-feature” variable annuities cost upwards of 5% a year with all the bells and whistles. Even for those who need the features that can be prohibitively expensive. And for those who don’t, it can be tragic.
Basic Annuity Anatomy
Let’s begin with a basic premise:
Annuities are life insurance contracts. Annuities are life insurance contracts.
Those are just words, even with the repetition and the emphasis. So what does it mean? It means that instead of a direct investment in an investment vehicle, annuity owners exchange their dollars for promises—with lots of stipulations—made by life insurance companies. These promises may be straightforward or convoluted, indeed. But instead of having direct claim over specific assets—like shares of stock, or dollars in a bank—you have accepted a promise, which means that you are at least one more step removed from what you had thought you were buying.
These promises can often appear to be thin shadows of the property you thought you were purchasing, for a variety of reasons, which we will explore.
It is very important to realize that while all annuities have certain aspects in common, each one is a unique contract written by the insurance company’s legal staff, and can vary tremendously from other annuities contracts, even those issued by the same company! It is important to read and understand to see just what you may have.
As “permanent” life insurance contracts, all annuities have two basic elements: a cash feature and an insurance feature.
The cash feature is ultimately an income one designed to pay income to the owner for some specified period, usually life. The insurance feature is some permutation of a death benefit, usually very watered-down, and usually very overpriced. We’ll look at some hard examples in just a bit.
Since we are talking about a life insurance contract, these are things that you have to apply for, though in reality not too many applicants are turned down, since state of health really plays no role in issuing the veneer of life insurance. In fact, in the annuity world, poor health should equal better rates, but hardly ever does.
On the application, besides the insurance company, there are three parties who apply, though they can all be the same person, and often are.
The first party is the owner. This is the person who has the right to all the benefits of the property, which is the annuity contract, and can access the cash value within the constraints of the contract, and can change those things the contract will permit, such as the beneficiary.
The beneficiary is the person or entity who gets the value of the annuity contract, if any remains, at the death of—you’ll never guess—the annuitant. There is more on the annuitant in the next paragraph. In this, an annuity is like a life insurance contract, except that the beneficiary gets the bundle on the death of the annuitant instead of on the death of the insured.
So what is an annuitant? As we will see in a bit, annuities are really designed to payout an income for a term which is usually based on someone’s lifetime—even the word annuity is heavy on the “annual.” If you think of a pension where the pensioner gets so much for life or a little bit less for their and their spouse’s combined life, you will have a good idea of the basic premise of an annuity.
I know, I know, most of us think of annuities as accumulation products, and maybe the agent never told you about the automatic conversion to lifetime income provisions on page 46b of the contract. But trust me, they’re in there.
Now, since the whole basic premise of an annuity is to generate lifetime income for someone, it matters who that person is that the contract’s payout features are to revolve about. How old they are—and how long they might live and collect—is a big one, for instance. The person whose life determines the annuity’s payout behavior is called the annuitant. Insurance companies often describe the annuitant as the “measuring life,” but that doesn’t really tell us much by itself. So now you know: the annuitant is the one whose life determines the payout of the annuity. For instance, if a “pure life,” or payout only for the annuitant’s lifetime, option is selected, then income stops at the death of the annuitant—and whose also is the life which acts as the insured so long as there is some life insurance benefit to the annuity. The annuitant has no rights by virtue of being the annuitant; the life of the annuitant is simply a yardstick. Permanent conversion of an annuity’s accumulation value into regular income—a process that cannot be undone—is called annuitization. Annuity contracts specify some future age at which this will happen automatically, but most folks die or clean the contracts out long before automatic annuitization.
The owner controls the contract, and gets to pick the parties at inception (usually once the contract is issued, the annuitant can never be changed). The beneficiary gets whatever life insurance value may be left at the death of the annuitant. The same individual can—and often does—play all three roles. Groups of people can also play any or all roles: Jim and Jack can own a contract measured by the joint lives of Jane and Jill, with John and Joan to split the proceeds if the annuitants die. And we are not even into contingent beneficiaries yet. But there still are only three basic parties, even if each party really looks like a party!
It is interesting to note that many insurance companies specify a maximum age allowed for annuitants and actually cut the commission rates that they will pay salespeople for older annuitants. It is for this reason that unscrupulous agents may sometimes suggest that a younger spouse or child be specified as the annuitant, but this can be a very poor move for the annuity owner, for both tax and liquidity reasons. The reason that life companies prefer younger annuitant ages is twofold: most contracts will waive the surrender charges (fees to access principal in early years) at the death of the annuitant, and the older the annuitant, the sooner that will be, statistically speaking, and the shorter the insurance company will have the money available to recover sales commissions and profit on; the other reason is that the older the annuitant, the sooner the contract will automatically annuitize, and the sooner the company will have start paying out an income, which can also cut into profitability.
Why all the annuities hype – huge profits for insurance companies
Why would the insurance industry pay so much in commissions?
First, a little history.
Conceptually, the life insurance industry makes money in a pretty straightforward way: you buy insurance and send in premiums over years or decades, and if you don’t die (most of you won’t on the timetable of most policies) the companies invest the money, and keep a very healthy portion of the profits on investing your premiums. In actual practice it gets (by design?) wickedly complicated, but that’s the basic mechanism. In the words of David D’Alesssandro, once-CEO of John Hancock, in his book, Brand Warfare: “In some ways, life insurance is a very cold business, like bookmaking or loansharking. We bet you’ll live longer than you’re willing to risk, and then we loan out—or invest—the money you give us at an attractive rate of return.” This methodology applies with a vengeance to deferred annuities, with the added bonus of virtually no insurance risk to the companies raking the cream off the returns on the annuity premiums given to them.
But let’s show some compassion: the last few decades have been hard on the life insurance industry, what with a steady decline in sales of incredibly profitable—and usually grossly overpriced—“permanent” life insurance products like whole life and universal life, increasingly disloyal and mercenary sales people, and the onslaught of class action suits to settle rampant misleading sales tactics across the country, and spanning many years.
It’s rough. Competitively priced term insurance—which in my humble view is all the vast majority of us need—is a relatively low-margin product: profits are low, commissions are low, the dollar amounts for all, customers and companies, are quite small. The term business is very competitive, and the product easy for the consumer to grasp and shop, unlike cash value insurance. Fair profits can be had, but excessive ones are kind of hard to orchestrate, since term is so doggone easy to understand. No cash value, no loans, no surrender values, no “bonus interest”, no smoke, mirrors, or peas under mattresses or shells. Simple: you pay x, and you get y. /p>
A bright spot in this change for the honorable life insurance industry has been annuities. Some of these data are dated, but they make an important point. /p>
As far back as the early 90s, “investment income and annuity premiums account[ed] for roughly 60% of the total income of U.S. life insurance companies,” according to The Institute of Business and Finance. More than half. And this number is probably growing as margins on “real” life insurance products continue to be squeezed by consumer enlightenment. It is quite possible that the percentage of insurance companies’ profits derived from annuities is far higher today. /p>
Annuities have exploded in popularity, some would say largely driven by commission-baited sales pressure, and seem to have become a dominant investment form on the financial landscape. How dominant? /p>
Variable annuities (the kind often described as “mutual funds in an insurance wrapper”) had grown to represent about one trillion dollars (that’s one million times one million) of investment capital by 2001. That was about two and one half times the amount invested in the long-term U.S. Government securities known as Treasury Bonds for the same period, and there was an awful lot of money, both here and abroad invested in T-bonds. /p>
Two and one half times that much in variable annuities alone, plus the billions piled on billions of dollars in the much more obscure “fixed” annuities marketplace. When we add this in, the total soars to $1.8 trillion—$1,800,000,000,000—which was more than ten percent of the entire national debt! And the number was growing as of 1999 by almost 18%—over $300 billion—per year.
Let’s talk about the kind of profits that would drive these companies to pay such commissions to acquire the business. I’ll use data from the variable annuities part of the business, because I have the numbers handy, and because government disclosure requirements for these securities products make the information a lot easier to get. Data on the fixed products is much harder to ferret out, making analysis far more difficult. Readers take note: equity index products are not securities and the SEC disclosure rules don’t apply!/p>
First, we’ll take the life insurance charges that are part and parcel of any annuity, being life insurance contracts, after all. The insurance for deferred annuities can be mostly weak and undependable, since, in most cases, the death benefit is really just a withdrawal of your investment—your own money back! For now, let’s just look at the cash flow these beasts provide for insurance companies. A typical life insurance charge (called a mortality charge) is 1.25%, those these seem to be creeping up at frightening rates. It doesn’t seem like much until you do the math. You need to hunt through the prospectus or contract to find out what these are for sure.
Of course, the real world tends to be more complicated, and insurance companies do face longevity risk (the risk of people living longer than expected, and receiving annuity income past normal life expectancy). This applies when insureds actually use annuities for the reason they were originally designed: to convert assets to pension-like income. This does impact potential profits, as do other aspects of these very complicated insurance contracts.
If we assume an average mortality charge of 1.25% on an asset base of one trillion, we get annual premium flow of twelve and one-half billon dollars, which looks like this: $12,500,000,000. There may be some death benefits paid out of this, but as we will see later in the report, they may be so nominal as to be trivial. But wait, there’s more.
In addition to the insurance charges, the insurance companies “mark up” the underlying mutual funds from what you would pay if you bought them directly by something like .75%, and often much, much more. Again, it doesn’t seem like much, but adds up to another seven and one-half billion dollars on an asset base of one trillion. That number looks like this: $7,500,000,000. Added to the mortality estimate, that makes twenty billion dollars. Per year. That’s $20,000,000,000, or twenty thousand times one million. It’s a lot of dough, and it’s just the tip of the iceberg of the annuity empire. We haven’t yet even touched fixed annuities or the newer “equity index” varieties that have been skulking about for a decade or so. If we double the number to very roughly estimate the other products, that’s $40 billion a year. $40,000,000,000 in revenue they never have to bill for, or clearly tell a single customer they charge. We need to borrow a word from the life insurance industry and make clear that I have merely illustrated what the total revenues might be using the assumptions I’ve outlined. The actual number may be larger or smaller, and the analysis has been pretty simplistic —and again the data is dated. On the other hand, for some products like variable annuities, costs have actually gone up, what with riders, mortality, underlying fund costs, admin and policy fees, and so on—so it is not at all unusual to see total costs pushing 5% a year on some product—almost always under the radar, and nearly never accounted for on statements or other regular notice. I don’t know about you, but in this economy a 5% shave off the returns is a very big deal! If the basic return were 10%, you would get 5%. If it were 5% you would get 0%. If it were 0% you lose 5%. And if it were a 10% loss, you would lose 15%.
Back to insurance company potential profits. Any way you slice it, it is clear we are talking about a mammoth number. These billions of dollars flow in year after year, as long as the contracts stay in force. And usually with no advice, no real management of the money from the consumer’s perspective, which is ultimately up to customer, who probably believes the agent or some elves are watching the money carefully, but that’s often an illusion. That’s another very important point: if you thought the agent or someone in the home office is actually managing your money to your objectives, you better look again, because the odds are overwhelming this is not the case, whatever the agent may encourage you to believe. As a non-fiduciary “advisor”, they have no obligation to put your interest first or provide any other service besides showing you a product you are responsive to kick the tires and read the disclosure on.
Is it any wonder that the insurance companies are willing to front high commissions to tap into a 40-billion- dollar-a- year cash flow? So forget all that talk about clients first. They may say it and maybe even believe it, but in too many cases, they don’t act or charge like it—and in many cases, they can’t legally do it anyway. Insurance company profits pay big commissions that motivate salespeople from stockbrokers to bankers to financial planners to credit unions to push this stuff. Companies first. Need that cash flow! Commissions for salespeople second. Gotta motivate ‘em! Move that product! Customers get what they get, which is usually confused and underserved—or outright disserved—in a blissfully ignorant way.
The beast has a number, and it is humongous.
The shear size and nature of the annuities market may amaze you. Billions on billions—thousands of billions, actually—are parked in these hard to understand products. Annuities have become a ubiquitous feature of the financial landscape in the United States.
Tens of millions own them. Many consumers don’t understand them. Even now, outside of the industry, it seems a little-known fact that annuities are, by definition, life insurance contracts. Regulation is spotty, and left to the individual states’ departments of insurance: there is no Federal regulation of the life insurance industry, a status which the industry has doggedly and expensively lobbied to maintain for the best part of a century. Given that the products are poorly understood and imperfectly regulated, the potential for abuse, both in pricing and sales practice, is too high. Not that there are not fairly-priced annuities with little or no commission load and reasonable insurance and management fees, though even these are poorly accounted for to those who own them. But there is enough of the loaded stuff, and far too much of the super- loaded stuff to make an informed person concerned.
These contracts are far more pervasive than all but a few insiders know.
Nearly every pension, lottery payout, and lawsuit “structured settlement” is funded by an annuity contract, for which a life insurance company is paid. Teachers, hospital workers, and other “403” (these numbers refer to the Internal Revenue Code section describing taxation of specific plans) groups have had as their primary retirement vehicle TSAs or “tax sheltered annuities” for decades. A majority of government- sponsored “457” deferred compensation plans and pensions are funded by annuities. A large percentage of “401(k)” and other corporate-sponsored retirement plans are annuities-based. There are dozens of other platforms on which these products are sold, from IRAs at the local bank or credit union, to “tax-shelters” (not really) to the wealthy and middle class. Life-insurance agents—since the 1980’s enthusiastically joined by brokers, financial planners, bankers, CPA credit unions, and many others—have been convincing individuals to plow savings and investments into these products for decades.
Due at least in part to the lack of Federal oversight, it is difficult to research total industry statistics to determine just how many dollars are tied up in annuities, and how may people have ownership interests in these contracts. I provide piecemeal hard data from several sources. But it’s clear that we are talking about many, many millions of people, and trillions (1,000,000,000,000’s) of dollars. The magnitude of the dollars controlled by insurance companies in annuities is truly staggering. The Variable Annuity Research and Data Service (vards.com) indicates that 2000 year-end assets controlled in tracked variable annuities contracts (not all contracts) alone was $973 billion for the insurance companies it follows (not all companies). Factoring for the 10% of companies not included by VARDS gives an asset estimate of $1.08 trillion dollars in this one sort of annuity alone.
Consumer dollars continue to be funneled into variable annuities contracts at a dizzying pace: for the 25 companies tracked by VARDS, 2000 year-end “premium flow” was $138 billion, representing an approximate growth rate for the year of 17%.
The American Council of Life Insurers (acli.com) is another industry group, which reports on and for some 80% of U.S. life insurers, and purports to have comprehensive data (though even they must estimate) on annuity totals. For all annuities (including the “fixed” sort which are pure life insurance contracts without the securities elements which make variable annuities “variable”), they reported 2000 year-end total annuity assets at $1.8 trillion, and a ’98-’99 (the last year for which I had data when I wrote this in the 90s) asset growth rate of 17.8%, which, if used to extrapolate the 2000 number, would give another third of a trillion dollars for 2001. ACLI reports that there were at the end of 2000 some 73 million annuities contracts “in force” (active).
These numbers are stunning:
$1.8 trillion—$1,800,000,000,000—was tied up in annuities policies, a number so astronomically large as to elude meaning. Let’s put it in context: this number was so huge as to exceed 10% of the United States’ national debt around that time ($17.7 trillion)! That’s nearly $10,000 in annuities assets for every adult—citizen or no—counted in the 2000 Census (about 197 million). And with 73 million annuity policies out there, we’re talking about nearly three contracts for each adult human living in the United States.
Of course, the concentrations, both in contracts and dollars per household, are certainly far higher in “mainstream” America, those who are citizens and above the poverty line.
Market penetration of annuities products is clearly deep. They are pervasive, and very poorly understood.
These products are overwhelming owned by individual consumers, perhaps being largely shunned by institutions due to high costs, oppressive taxation, and, frequently, very high commissions. Individual savers of every stripe own them from minimum-wage hospital workers in their TSA plans to millionaires who buy on the advice of brokers and bankers, perhaps because annuities pay higher commissions than other investment and savings products (a $50,000 commission on a $500,000 is not unusual, and the commissions can go much higher—I’ve seen as high as 25%, or $125K on $500K on a case I saw in the 90s).
These vast pools of consumer capital are parked in what are very complicated products that nearly no one—sales agent or purchaser—seems to completely understand, and which enable a host of obscure means for insurance companies to hang on for continued revenue to the assets by effectively—through complicated contract provisions, surrender charges, and high taxation—discouraging access by their owners, and to handsomely potentially profit (if we estimate hidden insurance charges and fees at 2% of assets, that’s $36 billion in annual low-maintenance revenue for the industry) in ways which are onerous to uncover, and which seem never to be even remotely accounted for to those who own them.
Many of you who own these products might wonder about just what you bought, and have a nagging suspicion that something may not be quite right. You may have vague uneasy feelings about them, perhaps intuitively guessing that they are not the best products for your needs, but lacking the information required to unravel these amazingly complicated products so that you can examine your suspicions. And the booming collective voice of the commission-driven annuity pitchmen drones like a dike against a flood tide, drugging the uneasy feelings, and keeping the dark pool of anonymous annuity capital growing by hundreds of billions per year.
I wrote much of the forgoing some time ago, and my views on annuities have since become a bit more circumspect. As I mentioned in the beginning of this report, annuities provide a service—guaranteed lifetime income—that nothing else does, and properly applied serve a critical role in financial planning for many people. That said, too often I have seen products purchased for the wrong reasons—expensive guaranteed income riders for clients who had high pension income and no need for annuity income, to cite a recent example—that my original buyer beware message is as important today as it was a decade ago. If you have—or may need—these complicated devils, do yourself a favor, and consult with someone who truly understands them, and your needs, to up the odds of a good and cost effective fit.
Incentives to Sell Annuities – Agents and Companies
Why all the annuities sale pressure? Why are annuities seemingly being pushed by nearly every bank teller, broker, agent, and financial planner, sometimes with all the enthusiasm and sweaty persistence of a carnival huckster?
In too many cases, it is more about commissions than client needs.
Commissions can start at what some would consider reasonable—like 4-7%—on the “fair compensation” annuities and can reach a wallet-busting 25% or more on the most client-pounding products than we’ve seen over the years.
As an outlier example to make the point, let’s do the math on a 25% commission product: that’s a quarter-million- dollar payday for a few hours work in convincing someone to “deposit” a million dollars in a “high interest” annuity. Such abusive products are unusual, but I have seen them out there—and the smoke-and- mirrors accounting that many hide behind can make true costs very difficult to spot besides being very hazardous to your wealth health.
Of course, the money to pay those commissions does not magically appear, but rather can only come from the pocket of the purchaser in a manner so oblique and undisclosed that he probably will not even feel his pants move, unless the agent tells him, which can be far too rare.
Let’s put this in “true story” terms.
In the early 2000’s, I met a nice couple in their late 60s who had been approached to buy an annuity from a nice man who gave seminars in the local library. The product seemed to offer the chance to make money in the stock market, while at the same time giving strong guarantees of principal and interest. So far, so good.
They were tempted, but wanted a second opinion, and asked me to look at the brochure.
The first disturbing item was the surrender charge schedule: it would be fifteen years—to age 83, or so—before these folks could get their money back with no penalty. The penalty was a whopping twenty five percent—$75,000 on the proposed “investment” of $300,000—for the first five years of the contract. As I dug deeper, I learned that the interest guarantee was so low as to seem like 0%, and that the principal guaranteed—before surrender charges!—was only 70% of what they invested, or $210,000 of the $300,000 proposed!
In other words, a guaranteed loss of 30% right off the top.
Then they would have to pay the 25% surrender charges on what was left if they wanted their money back!
If they wanted to cash out quickly (like for a life-prolonging operation or because they found a better investment option like a high-interest bank CD), here’s what they could count on:
Initial annuity premium $300,000
Guaranteed 30% loss ($90,000)
Pre-surrender charge value $210,000
Surrender charge 25% ($52,500)
Guaranteed principal value $157,500
Total charges/Net loss: $142,500 47.5%
On three hundred thousand! Almost half their money! This is the “guarantee” that this retired couple really would have had when asked to “invest” every nickel in the world that they had! Of course, the nice man from the library did not explain it that way. This amounts to an effective surrender charge of nearly 48%.
Furious, I tracked down the insurance company, which manufactured the annuity the next morning in the Midwest, truthfully told them I was a licensed agent interested in this product, and asked for the commission schedule.
They paid $51,000 of this couple’s $300,000 to agents willing to sell their annuity.
Enough for the agent to buy a boat in cash.
Forget for a moment the questionable motives of the nice man from the library selling this fine product.
Why in the world would an otherwise reputable insurance company—and this one’s been around for over a hundred years—be willing to compensate a sales force so handsomely to distribute its product? How could it afford to pay what most would view as obscene and abusive commissions? Why would it?
Because of profits.
Some would say unreasonable profits, and some would use stronger language. Profits that may boggle your mind when we rip them, still wriggling, out of the Byzantine contracts that produce them, and lay them bare in the sunlight for you to see.
To some, it may seem that cases like this suggest some insurance companies, hungry for profit, have made monsters out of their salespeople, and reduced the investing public to no more than faceless cattle, obliviously awaiting the sharp edge of the commission knife.
Is this an isolated, one-in- a-million situation that has somehow slipped by the regulators? Sadly, I don’t think so. While at the more extreme end of the spectrum of annuity sales abuse, cases like this can seem all too common and have been happening for years. Though one would expect that competition and disclosure should drive costs down to the benefit of the consumer, alarmingly, things seem to be going the other way: buried insurance and other costs have appeared to be rising. While there are reasonably priced “good deal” annuities to be found—we’ll show you where, later, if you want or need them—they can sadly be the exception to the rule of the blizzard of high-pressure, high-commission annuities littering the modern financial landscape.
What makes annuities so easy to push so hard? From the salesperson’s—the agent’s/financial planner’s/banker’s/stockbroker’s—perspective, those big commissions make these products easy to love. The percentage paid out in commissions seem unrivaled in the legitimate investment products world, with some so high as to approach the stratospheric levels paid out to push some life insurance. As we’ve already seen, in my experience, annuities’ commissions have been as high as 25% of the investment in the worst cases.
These big commissions are almost always of the “back-end- load” variety, which makes them less than obvious to the prospective customer, even when the surrender charges are properly explained by the salesperson, which isn’t as often as one might like. And even when they are mentioned, it is usually done in such a way as to make them seem far less expensive than they really are.
Back-end- loads (called surrender charges in the insurance industry) work like this. We’ll use an example from the real world I researched a few years ago. A product called “P-10” has a surrender charges schedule described as 12/12/11/10/9/8/7/6/5/3/0, in the standard format for such things. What this means is that if you “surrender”—ask for your money back—in the first year after they cash your check, they’ll keep 12% of your initial investment as a surrender charge. If you cash out in the second year, the cost is also 12% of your initial deposit, 11 % the third year, and so on, until the surrender charges are gone in the eleventh year. This product, by the way, paid a 9% commission. These charges are at best “semi-hidden” from a sales perspective, making them much less obvious during the sales process. Normally, you see what they are in print in only a few obscure places: in the prospectus, if it is a variable annuity (if it is not a variable annuity it is not regulated by the SEC and you get no prospectus); sometimes in small print on the application (an annuity is an insurance product, after all, for which you have to “apply”) or on a separate gray scale disclosure form; and somewhere in the annuity contract, which you don’t get until after they’ve cashed your check, and likely paid the commission. Much more prominent, on the statements, in the contract, on the salesperson’s lips, and on your mind is the “accumulation value,” the amount we’ll pretend you have if you do not want all of your money back. Eventually, after the surrender period has passed, the accumulation value is the same as the surrender value. But try to get out sooner, and you may be shocked to find that the surrender value is a whole lot less than you thought you after surrender charges, forsaken “bonus” interest, and other costs. Talk about “substantial penalties for early withdrawals!”
The best agents will go through the surrender charges with you as part of the process, but don’t expect them to not downplay it—their income depends on your purchase. Some agents may not mention it, knowing that you will probably not even know they exist or where to look. The worst will mislead you about them, even when confronted with a printed surrender charge schedule, telling the customer that they misunderstand. If you hear, “Don’t worry about fees or commissions! I’m paid directly by the company!” your guard should go way up. Ditto if they look you in the eyes and tell you that you pay no commission: while at best this may be half true (since the company technically pays the commission after they take your money) it can be extremely misleading since the commission comes directly out of your pocket. Ask instead if the sale rep is making a commission—and get the answer in writing. The vast majority of contract owners never discover these charges—or the high annual fees, either—unless they try to cash out, or someone like me reads the material and points them out.
So the back-end loaded nature of annuities makes it a lot harder from an investor’s perspective to see what’s really going on, at least initially. This makes them easier to sell. For instance, if you had a 10% front-end (off the top) commission on a $500,000 investment, it would soon be obvious to you—as soon as you got a statement or the annuity contract—that you only have $450,000 left and that you paid what you might consider a huge commission. If you were told this up front, you might not buy, and you will raise bloody hell pretty quickly if you were not. If, instead, everything you get says $500,000 except the fine print you never look at, you are much likelier to buy and keep, even if you know about it up front, because you can pretend it does not exist. Even when it’s not that bad, it is usually easy to be confused and not catch the surrender charges. Take note: whether it reads like “we take $10K and leave you $90K” or “we’ve made believe you have $100K”, the $10K still comes out of your pocket. It can come from nowhere else.
Oh, and don’t expect the agent to rave about his or her commission. Most won’t mention it, and most will leave you with the impression that they work for free. Again, when pressed, too many will smile and say something like “don’t worry, I’m paid directly by the insurance company.” Which, of course, is literally true. But make no mistake, the money comes directly out of your pocket—it can come from no place else if the insurance company is to turn a profit. Sadly, most agents never know—or care to know—just how much you pay to them and the insurance company however indirect and obscure the math is, though they tend to be very knowledgeable about their own compensation, and many can even be caught secretly calculating their commission while they chat with you, if you watch carefully—some may even text their significant other about their pending windfall!
Why You Need to Get Educated about Annuities
If you or someone you care about owns annuities, this section of Wealth Matters could prove to be invaluable to you. And if you are considering the purchase of an annuity product—which probably means an insurance agent working for a bank, brokerage house, or “financial planning” company is trying hard to sell you one—reading this report first could save you anywhere from hundreds to hundreds of thousands of dollars, and help you make a much more balanced decision.
In a clear, simple language, that will sometimes incite you and occasionally amuse you. We will demystify these extremely confusing, complicated life insurance products, show you how they work, why they are often pushed so hard, and when you should probably avoid them, and when you should probably use them. We’ll talk about the life insurance feature that is present in all annuities and show you how much this often-unneeded feature can cost in real dollars and cents. This information will probably amaze you.
Some of what you read here you may find disturbing, as we unravel the ways insurance companies and agents profit on the sale and continuation of annuities contracts. This work is not intended to be an attack on the ethics of the practices of insurance companies and their sales agents—as in most things, there are good and bad companies, and good and bad sales reps. For the most part, annuity sales practices are conducted within applicable law, although there are not infrequent challenges which occasionally result in substantial settlements. The important point is that much of what we will describe here is currently legal. Just because it is legal, however, does not mean it is good for you or in your best interests. Like for most purchases, you must ultimately determine what is in your best interest. You’ll learn how annuities are priced, how the insurance companies sometimes make amazing profits from them, and why they are sometimes willing to pay commissions so high as to appear unconscionable to some. The sheer magnitude of some of these commissions in the most abusive cases may inflame you. Since these commissions are almost never disclosed, even if you ask, we will give you some very useful methods to estimate them for any given annuity, so you can see just how much a salesperson would be paid to motivate them to sell it to you. This is a very important point. If an agent says, “You will pay no fee or commission to buy this annuity,” this can be technically true, but it is mostly misleading. The insurance company pays the commission, not you. But it clearly comes out of your money, and can come from nowhere else. It also means that you have less money after the commission is paid than before you bought the annuity—it cannot be otherwise.
We will show you where to look and how to figure out just how much the many types of hidden fees and charges add up to for a given annuity product, and you will begin to see just why the insurance companies are willing to pay sometimes huge commissions to agents to birddog this business for them. The hidden fees and charges we will show you how to estimate are usually never clearly accounted for on any statements you receive on your annuity. You need to dig deep in a prospectus, sample contract and, sometimes, supplemental materials to have any hope of seeing them for what they are and what they cost you before you buy. Often, you will have to look in two or more places to gather all the information you’ll need to figure total costs. While this has gotten easier in recent years with online tools, it can still be very difficult for a consumer to get all the facts on costs and product shortcomings. But make no mistake, you can’t rely on the slick sales talk, brochures, and DVDs to tell you all you need to know—you need to research the fine print or find someone you trust who knows how to do it for you.
To be clear, as in most markets, product pricing ranges from really good deals to outrageous overpricing. Outstanding, no-load products have emerged in recent years, and quality companies offer solid contracts distributed by competent agents compensated by fair commissions for the guidance they provide. Some annuity products have emerged which offer outstanding guarantees and other features that justify the costs and commissions earned by the companies and agents. But sadly, there is still too much abusively priced, shoddy product from companies with questionable ratings and perhaps dubious sales practices. The problem with annuities is the sheer complexity and murky “disclosure” in this marketplace that makes it very difficult for consumers to tell the difference between good and bad products, needed and useless features, and other key points to make sound decisions. To be fair, there is much solid, fairly-priced, absolutely appropriate annuity product that satisfies needs as nothing but the right annuity can. But there is also so much abuse—particularly seniors’ abuse—in this area that consumers are warned to be especially diligent, and demand clear information and answers in writing.
We’ll talk about insurance company ratings, since the guarantees come from the companies’ promises—and abilities—to pay, and not from some rock-solid government program like FDIC.
We’ll get into the rather complicated tax treatment that annuities “enjoy,” and see why what is often touted as the big advantage of annuities can sometimes be a disadvantage, since these products can wind up being some of the most highly taxed vehicles in the “investment” world. If you already have annuities, this will help you understand your tax position and help you consider strategies to control and minimize the tax hit so that you can better plan to create the maximum wealth for you and the ones you love.
If you own annuities in otherwise tax-deferred programs like IRAs, 401(k)s, TSAs, 403(b)s, profit sharing plans, pension plans, and so on, you may be steamin’ mad when you realize that annuities confer absolutely zero tax advantage, and actually increase your costs—and so shave your returns—for no good reason but that using an annuity was more profitable for the salesperson and the insurance company than the many other more reasonably-priced investment vehicles that could have been used instead. The number of times we encounter annuities in these plans, in our professional practice, where the plan owner or trustee was not even aware that the product was an annuity—continues to shock even us, and we’ve seen it for years. Annuities offer no tax advantage in retirement plans, and the additional costs and expenses they can impose can really hold back the growth of retirement nest eggs.
On balance, we will also explain the benefits that annuities—and nothing else—can offer, such as guaranteed lifetime income and a way to manage “longevity risk” (the risk of outliving your assets), which can be a key feature in retirement planning.
We will clearly explain the different sorts of annuities, the kind that grow like investments, and the types where you forever exchange your money for a stream of payments, usually over your life span. You’ll understand the difference between variable annuities (those insurance products which are also securities products and are also regulated by the Federal government) and fixed annuities, which are only regulated by various states. And we will explain the newer equity-index annuities, those state regulated fixed annuities whose return is linked to the securities markets but always less than it, sometimes tragically less.
As we get into the various types, you’ll understand where the underlying returns come from, so that you can see just what the companies can afford to really pay you after their commissions, expenses, and profits, and just what you could expect to make yourself if you invested directly in the vehicles on which the annuities are based.
Annuities are universally touted as offering guarantees, and we will show you exactly what kind of guarantees actually exist, and how strong—and how sometimes truly weak—they are in many cases, so that you can judge if they are worth their sometimes-high price in your situation. You will find that the word guarantee is stretched to new levels of ambiguity for many of these products, and is often shamefully misused in actual sales practice.
We will talk about why the apparent “free lunch” of “bonus” annuities can be the too-good- to-be- true promise that you may have suspected, give you some guidelines to calculate what is really going on, how you must ultimately pay for any offered front end bonus, why you’ll never really get it, and how the insurance company amazingly still makes a ton of money even after their generous “gift.”
By the time you’re finished reading, you’ll be armed with a whole checklist of red flags to beware of in annuity sales pitches, and taught how to detect when the proffered advice may be intended to fuel commissions and profits at the expense of your own financial goals and security.
We’ll show you what your best options are if you are already “stuck” in annuities due to adverse tax consequences, how to perform tax-deferred exchanges, where to find reasonably-priced, no-load annuities, and why this just postpones huge, inevitable tax hits. We’ll also lie out clear strategies to convert annuity investments into less expensive and lower-taxed vehicles if you finally decide to get out of them.
You’ll learn the basics of appropriate sales disclosure, and be able to determine if all required elements were present when the annuity products that you own were presented to you. Then, we’ll show you what you can do to make yourself whole if a sale was improper, and whom specifically to make complaints to in order to restore your financial position.
Finally, we will end with a bunch of “true stories” case studies about annuities taken from my professional practice. These will amaze and amuse you, show you just how pervasive overzealous annuity salespeople seem to be, and how overwhelmingly un-alone you really are. But mostly these stories will anger and inspire you, and help motivate you to be careful, use trusted, competent advisors, and make your own situation right.
By the time you read these stories, you should already have all the knowledge and tools that you’ll need to make it right, for you and those you love. And you will discover if that if you have expensive and unsuitable annuities, the fault for this is probably not yours for not doing your homework, but rather that of a commission-driven salesperson whose responsibility was to fully explain the product and all the costs and limitations, and who was either ignorant of his or her craft or chose to overlook the knowledge in hopes of bagging higher compensation.
Annuities – guarantees against outliving your money
One of the most profound risks facing today’s retirees is that of longevity risk – the risk of outliving your money. For most people facing retirement today, traditional pensions, with the exception of Social Security, are very much a thing of the past. For most folks, Social Security provides a very baseline sustenance income, but is not nearly sufficient to fund a comfortable retirement. The balance must come from personal savings, but if we do not invest well, live too long, or both, odds are good that the well will run dry, even without the added risk of higher heath or long-term care costs. Annuities are really the only practical way to control this, offering lifetime, guaranteed payments. Like most things, such guarantees come at a price. We may not live as long as we hope, and risk getting less back from the insurance company than we pay for the guarantee. This, of course, is the only way the insurance companies can afford to pay for those that live much longer than expected. The other risk, though, is less obvious. Inflation (the high risk of rising prices, especially for things retirees really need, like health care, medication, and other lifestyle assistance) is not well addressed by most available annuity products. Unlike Social Security or traditional pensions, cost of living increases are not typically found in available guaranteed annuity products, or extremely expensive (read even lower payouts) when found. For most folks, a retirement income strategy combining Social Security, a limited amount of pensionized assets in quality annuities, and a pool of well-managed risk capital is probably the best compromise and best shot at achieving retirement goals. But note: doing so during a period of low interest rates – like the present – locks in the payment to you forever in many products. Think of a fixed rate mortgage with a low rate – payment is much lower that if the rate is high. For borrowers, low rates are great, but no so good for lenders, especially when rates (and inflation) go up. With annuities, think of yourself as the lender, and be wary of locking yourself into low income payments for life, when rates and prices and everything else may go up.
Annuity guarantees – some are weaker than they sound
At the end of the day, annuity guarantees are pretty much only as good as the insurance company’s ability and willingness to pay your money back. While there are state guarantee funds to backstop failing insurance companies, these are nowhere near as robust as FDIC and should not be considered absolute guarantees. If the insurer goes belly up, it may be years before you get your money. You may not get all of it. If the fund goes dry, there is no telling what might happen.
So be warned. For this reason, insurance company ratings—similar to the bond ratings that help you gauge how likely you are to get your money back—are critical. Unlike junk bonds—junk because the promise of bond repayment is questionable—annuities don’t trade on a marketplace, and can be very illiquid considering surrender charges and redemption issues if a company gets into trouble. My suggestion is to stick with top-rated companies and also stick to those you expect to remain top rated over the period before which they will hold you money, perhaps as long as you live, or longer. Remember, things can change, and a company sporting top ratings now may be a completely different animal later in your life.
The lure of lower rated companies can be high, since they will often offer consumers tempting features like above-market bonuses and more lucrative return formulas. Remember that they will offer better terms because they may have to get investors to overlook the higher risk of defaults, and will usually spin their ratings story as positively as they can. Don’t forget that old “let’s put some lipstick on this pig” commercial. Remember, that lower rated companies will often offer higher commissions, trips, and production bonuses to agents to get them to overcome their aversion, and that big payouts can make for a powerful sales pitch. If you choose to use a lower-rated company, be smart, and only invest on the same limited basis you would consider for any other higher risk investment.
Annuity red flags checklist
If any of the following apply, you may want to deeply consider if an annuity was properly sold to you and you should get an outside second opinion (like by requesting our free Portfolio Stress Test) or consider adjustments or alternatives to your annuity product(s).
You don’t have a need for income from your annuity products.
You don’t clearly understand the connection between your annuities and income
feature you need.
Commissions, costs, and surrender charges were not clearly explained to you.
You were sold annuities in an IRA or other retirement plan and conversion to a pension-like income stream was not the primary reason for buying the annuity.
You don’t understand how and how much your annuity sales agent was compensated and how you pay for this.
The ongoing costs for investments, riders, guarantees, life insurance, policy fees, market value adjustments, and other potential charges are not clear to you.
You believe an advisor or insurance company is regularly overseeing and managing your annuity investment options.
The annuity was positioned as almost too good to be true, and you have a sneaking suspicion that something is not quite right, but can’t put your finger on it.
Asset Protection in Life Insurance & Annuities
In Florida, life insurance and annuity cash values enjoy very strong, constitutional protection, but possibly only so long as the cash stays in the contract and is not withdrawn for other use; do that - and this is true for virtually every protected structure - and the cash may be on the table to be attached by judgment creditors, if they can find it. We have found that many doctors put a lot of money into life insurance, for this and other reasons. This protection must be weighed against the commissions and ongoing costs in these insurance products, and they can frequently be very high, indeed, making them poor choices from an investment standpoint because of these high costs. Note that life insurance agents can make very big money on insurance and annuities commissions, and they would not be human if this did not color their advice and sales pitches; very often, we have found that doctors can benefit enormously from an insurance review that is not driven by commission considerations. Low cost "no-load" life insurance and annuity products have emerged, but tend to not be pushed by salespeople since they won't make much off them, so they are off most consumers' radars. If you have such an insurance product, note that most can be "rolled over" to similar products, continuing the protection but enabling you to shop for low cost alternatives if you have someone familiar with these and willing to do so for you. Note that there are typically three parties to an insurance or annuity contract, besides the insurance company: the insured (annuitant), the owner, and the beneficiary, and that these need be properly named for the strongest protection. As with asset protection and estate planning, a competent review in this area can result in significant saved money and financial improvement; we have done this for many doctors.
Case histories of troubling annuities sales
The following stories are based on actual situations, and shared by people we have met in our professional practice. Their names and non-material details have been changed, so as to protect their identity. In short, the stories have been fictionalized to save those affected further embarrassment.
The essential facts dealing with product representations and sales practices have been faithfully recorded. These tales will amaze, amuse, and incite you. They may also inspire you to take action.
Most importantly, they will help you to realize that you are not alone, if you feel that you may have been subject to less-than- forthcoming annuities sales tactics. From the incredibly high frequency with which we encounter stories like these, we can only infer that this kind of monkey business is nearly epidemic where these products are concerned.
Some are truly beyond belief. And we see things like this every day.
Deferred annuities (remember, they are by contract only immediate annuities in waiting, designed ultimately to annuitize the accumulated value into a payout stream on which the insurance company still plans to make money) are packaged to really look like investment products.
It is therefore the payout—not taxes, as so many improperly infer—that is deferred in deferred annuities. It is this payout function, latent and lurking in deferred annuities, which is what makes an annuity an annuity. Never forget this.
With deferred annuities you put in so much—up front, on a regular monthly or other basis, or both—and hope to watch your money grow. With all of these, you need to beware of surrender charges, which are fees that you will pay if you decide to get out of your contract and move the money, even into another annuity contract. Some contracts will assess a flat percentage, which will usually decline a bit each year—or after each of several years—by a percentage point or two, until the surrender period had passed. These surrender charge percentages have ranged from the merely expensive—like 3 or 4 or 8 percent—to the truly outrageous, like 30% of your invested principal, or more. It doesn’t look like much, but 6% of $200,000 is $12,000, if you decide you want your money, and 15% of the same sum is $30,000. Surrender periods can range from a few years to over a decade or more.
It can be easy to rationalize away surrender charges because you plan to keep the annuity for a long enough term to get past them, but remember how tightly they can limit your options. If interest rates go up again, but your contract does not keep up (because the insurance company is stuck with the low-yielding investments they put your money in or knows you are unlikely to leave and pay a big surrender charge), you may find the liquid restrictions really cut into your returns.
Deferred annuities (remember, deferred really means that the annuitization component, gateway into the land of lost liquidity, is by contract deferred to some future date) come in two basic flavors, fixed and variable, though that line has been badly blurred recently by the advent of equity indexed annuities, which really have no equity but may – may – pay interest based on securities markets.
Fixed and Equity Index Annuities
The original flavor is commonly referred to as fixed annuities. These are the simplest to understand, and analogous to CDs and other deposit accounts at banks. It is important to remember that the guarantees on these insurance products are far weaker than FDIC-type guarantees on bank accounts. They pay specific annual interest, usually set in advance each year with guaranteed minimum interest levels. They can get wickedly complicated, what with bonus interest and other smoke-and- mirrors inducements, but at their core are very simple, at least for the insurance company issuing the contract.
The surrender value is the cash-out amount that you’d receive if you surrendered the contract and asked to move your money. The accumulation value is an amount that appears on your statements, as is what the contract is worth so long as you don’t ask for all your money. In some ways, it is a make-believe number, since the surrender value is all you have access to if you need more than just the interest and/or a small annual percentage of principal (usually 10%) of your money, which you can usually—but not always, check your contract—access free of surrender charges. So, surrender value is equal to accumulation value minus applicable surrender charges and other fees and “haircuts.” A haircut, by the way, is an old securities term for taking a chunk out of value for some reason. They should have used “shave” instead.
Interest rates are usually a bit higher than banks, since they do not offer FDIC insurance, which means that the guarantee of principal and interest is basically an insurance company guarantee and dependent on the financial strength and goodwill of the insurance company. Access to principal is often restricted, through surrender charges, for two primary reasons. First, in order to get a decent return (with a portion going to you), the insurance company will need to tie up the money for a longer period, and if they have to cash out of an investment in order to give you your money at an inopportune time, they will make you feel some of their pain. The second reason is because of the commissions they had to pay in order for a salesperson to bring them the business: if they haven’t had enough time to make a profit on your money on top of the commission they had to pay to get it, well, again, that pain’s for you.
This annual interest rate will usually be somewhere between mid-term (2-5 years) CD rates, and the rates actually paid on good-quality corporate bonds, mortgages, and the other things that insurance companies will invest in with the money collected in annuity premiums.
Market Value Adjustments (MVAs) are a kind of additional surrender charge that has nothing to do with commissions, and are a way that the insurance company sometimes uses to pass risk on to the purchasers of annuities. They’re kind of sneaky, and make fixed annuities with them act more like the SEC-regulated variable annuities that we’ll get into later—without the greater disclosure required of SEC- regulated products. They work like this: when interest rates go up, bond prices go down, which means if you cash in during a period of rising rates, the insurance company will get less for the bonds they put your money in. With MVA annuities, you will then get less, on top of any commission-derived surrender charges.
Let’s talk about bonus interest for a moment. Bonus interest is an extra percentage that an annuity may credit to your premium when you buy and can look awfully good at first blush. For a “5% bonus” annuity on $100K, your initial “deposit” is considered to be $105K . . . and then you’ll “get” whatever annual interest the product pays credited to your accumulation value as the months roll on. It is important to remember that we get little in life for free, especially from big financial institutions; when you get down to the nuts and bolts, the bonus is kind of nebulous. It has to be; if the insurance company could conjure money out of the air, it surely would keep it for itself. Believe me, any bonus is reclaimed by the insurance company in higher charges and fees over the years that you keep it, or in stiffer surrender charges if you try to pull your cash before they have time to nibble it all back. If you think carefully on this, you will realize that it cannot be otherwise. Remember the “too good to be true” axiom. Particularly troublesome is where these smoky bonuses are pitched to make up the surrender charges on products the salesperson wants you to replace with his annuity; since the bonus is a chimera, the hapless investor can be subjected to two surrender charges, when before the new commission (I mean the new annuity) there was only one. Bonus interest in general, and on replacements in particular, has attracted a lot of unwanted attention to the insurance industry from the insurance and securities regulators.
The last wicked twist on fixed annuity contracts is the increasingly popular equity index annuities (EIAs). These are important, and have become quite pervasive. These are enormously complicated contracts that pay interest that is based on the performance of securities indices, like the S&P500. Because they are fixed contracts, they can offer principal guarantees and guaranteed minimum interest, but often is so low as to appear negative even before the sometimes-massive surrender charges that they carry. Remember the example of the elderly couple and the “nice man from the library” earlier in the book? Surrender charges on that product—after receiving the guaranteed interest on only 70% of their principal—amounted to a whopping 48% of their money. The pitch with these is that you can have the security of a guaranteed product with the upside of the stock market—which is a very compelling notion. Of course, this kind of security comes with a cost. Besides surrender charges, EIAs often typically apply cap rates—your return is limited to some cap, like maybe 10%, even if the marketing goes up 100%. They also often impose participation restrictions, whereby you only get a portion of the return, with the rest going to the insurance company. For instance, if your participation rate is 80%, and the underlying index does 5%, you get .8 x 5% or 4%. The basic EIA structure is something like this: the insurance company bundles your money with that of other annuity buyers’ to buy a bond portfolio that pays interest. You get a portion of that interest, as does the insurance company, and some of it goes to buy options on the stock market; if the options hit, you get some of the gains, and the company gets some too. The principal guarantees are based on the bonds but ultimately guaranteed by the insurance company, not the bonds. This is really just the tip of the iceberg on these complicated, derivatives products, and you should read very carefully to make sure you understand before buying one. It gets much more convoluted, and can involve MVA risk, specific participation periods and methods, ongoing investor management requirements, and more. One last thing EIAs often share with other annuity types is multiple and misleading “accounts.” Besides tracking accumulation and surrender values, EIAs often have income accounts, a number that only has meaning if you decide to convert to income payments, but is not a cash value you can redeem. EIAs provide a bundle of features—convertible guaranteed lifetime income that can’t be outlived, principle and sometimes minimum return guarantees, and access to participation in securities markets’ returns without actually being securities—that are important and generally impossible for consumers to build on their own without an insurance company component. Products are attractive but very complicated, and are often expensive and come with potentially disturbing liquidity restrictions. In my view, EIAs offer some of the greatest benefits—and most dangerous pitfalls—in the investments landscape today.