Annuities and Senior Citizens

Given that I write a lot about foolish investments and investment scams, several colleagues questioned why I have never written about variable annuities. I know a little more about annuities than a lot of people.  When I was a young lawyer I worked at EF Hutton at the time it was first bringing “universal life insurance” to market. Universal life or “investment life insurance” was the precursor to modern annuity contracts.

There is already quite a lot that has been written by regulators and consumer groups about what is wrong with selling variable annuities to senior citizens. Variable annuities are intended to be long-term investments, usually 10 to 15 years or more. They have a lot of up-front fees that can take a long time to re-coup.  Selling investments that take a long time to break-even to senior citizens is always a problem.

At the same time, variable annuity sales to seniors are growing every year. The reason for this is that a variable annuity sale will pay the salesperson a very high commission; higher than the commission on almost any other financial product.

The commission on a variable annuity contract may be 7% or 10% or more of the amount that you invest. If you buy a million-dollar policy, the salesperson who sells it to you may earn a commission of $70,000 or more. For comparison if you invest $1,000,000 into a series of no-load mutual funds or ETFs at a discount brokerage firm the total commission may be less than $100.

Variable annuities are the only kind of investment which requires the salesperson to have both a license to sell insurance and a license to sell securities. Theoretically that should mean that they are better trained than many brokers. That does not necessarily mean that they are supervised more carefully.

A variable annuity salesperson is often licensed by a brokerage firm owned and operated by an insurance company. The intent is often to facilitate the sales, not provide an extra layer of compliance. Insurance companies rarely lose money and variable annuities are some of the most profitable products they sell.

Variable annuities are often complicated and difficult to compare. No two annuity contracts are exactly alike. Even annuity contracts with the same name offered by the same company can contain different riders that substantially change the terms and benefits.

The salesperson with whom you speak will only be able to sell you an annuity contract issued by one of the few companies with whom they are licensed. If you want to shop around for an annuity you may need to contact several different salespeople.

With a variable annuity your money will be invested in a series of mutual funds or sub-accounts that are managed by the insurance company.  The insurance company may offer a range of investment options. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments or some combination of the three. The track record of the fund managers is not always easy to find or evaluate.

The value of your investment as a variable annuity owner will vary depending on the performance of the investment options that you choose. If your intention is to allocate and re-balance your portfolio within the annuity you should understand that it will be difficult to do so properly. The funds will not necessarily correlate well with each other and may not balance against each other in such a way as to substantially reduce market risks.  The person who sells you the annuity might not be able to offer you good advice on how to allocate the portfolio now or when to re-balance it.

You will pay a management fee for each mutual fund. As with all mutual funds, fees will reduce returns. The “expense ratio” of each fund should be disclosed to you. Over 10 or 20 years those fees can add up to a substantial amount of money. Your portfolio will need to earn that much more than the market every year for you to match the market’s performance.

The insurance company will also offer to sell you various guarantees which may provide for a minimum return every year even if the market goes down. You will pay for every rider and option that you select. If you add all of the annual fees you will see that variable annuities are a very expensive way to invest.

A common feature of variable annuities is the death benefit. Often the rider will provide that if you die, a person you select as a beneficiary (such as your spouse or child) will receive the greater of: (i) all the money in your account, or (ii) some guaranteed minimum (such as all purchase payments minus prior withdrawals). Other features may include long-term care insurance which pays for home health care or nursing home care if you become seriously ill.

Most variable annuity contracts include an annual mortality and expense (M&E) fee. This charge is equal to a certain percentage of your account value, typically in the range of 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurer’s costs of selling the variable annuity, such as a commission paid to your financial professional for selling the variable annuity to you. The company may include the fees for any guarantees that you buy or may charge you separately for them.

If you withdraw money from a variable annuity within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as ten years), the insurance company usually will assess a “surrender” charge, which is a type of sales charge. Generally, the surrender charge is a percentage of the amount withdrawn, and declines gradually over a period of several years, known as the “surrender period.”

For example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the eighth year, when the surrender charge no longer applies. Often, contracts will allow you to withdraw part of your account value each year – 10% or 15% of your account value, for example – without paying a surrender charge.

Annuities are most often sold as a way of funding your retirement. They do have tax benefits similar to an IRA account so they are rarely purchased with IRA funds.  If you have a large amount of money put away for your retirement outside an IRA, you should consider that the amount you might actually receive annually from a portfolio of dividend paying stocks and bonds might compare favorably once you consider the higher risk that you will have to make up for the annuities annual expenses.

The very first thing I learned about insurance in general (way back at EF Hutton) is that people do not buy insurance, people sell it. Annuities are a high commission item. If you are considering them, get advice from a fee based financial planner first and consider all of your alternatives.

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