Ask A Lot of Questions Before Buying An Annuity
I call my son the “Question Man”. He asks me, on average, oh, a gazillion questions a day . Well, maybe not that many, but I do find myself on some days limiting him to a set number. His twin sister isn’t far behind him with her own set of inquiries. Sometimes it feels like a never-ending interrogation with the two of them playing good cop/bad cop. All that’s missing is a windowless room with a table, chair and one stark light bulb shining in my face.
Actually, I appreciate their inquisitiveness. They have a keen desire to know and understand all that’s going on around them. As adults we tend to lose some of that unabashed quest for answers. Of course it’s not always about the number of questions we ask but about asking the right ones.
Recently, my firm talked to two different clients who thought they had asked enough of the right questions about annuity products they owned. In reviewing their annuity contracts, we discovered that these clients didn’t have exactly what they thought they were getting. They weren’t happy to learn they had bought a sales pitch and now owned a product that didn’t meet their needs or expectations.
In its most simplistic form, an annuity is a contract between you and an insurance company to provide either a regular stream of payments or a lump-sum payment at some point in the future – typically after retirement or age 59 1/2. You can fund an annuity with a lump sum or payments over time. Like retirement plans, annuities grow tax-deferred, but unlike retirement plans you can contribute as much you like to an annuity. You also do not have to start taking distributions when you turn 70 ½ as you do with a 401k or IRA. Word to the wise – you should not consider funding an annuity unless you have maxed out pre-tax contributions to your 401k, 403b or IRA.
Annuities can be fixed – invested in government securities and bonds and pay a fixed rate of return – or variable – invested in a range of mutual funds and stocks known as sub-accounts within the annuity. They can be either deferred or immediate. Deferred annuities have an accumulation phase of longer than 12 months during which the premiums appreciate. Immediate annuities do not have an accumulation phase - a contract is purchased for a lump sum and payments begin within a year.
Annuities are practically evolving on a daily basis and have become a popular solution to the retirement income question. When you purchase an annuity, you are transferring the risk of longevity and outliving your income to the insurer. However, you’re also giving up full control of your money, and you’re counting on the insurance company to remain solvent and hold up its end of the deal.
We can thank the baby boomers for a rapid influx of new variable annuity products with a myriad of bells and whistles in the form of living benefits, also referred to as guaranteed withdrawal benefits and guaranteed income benefits. A “guarantee” sounds good, right? It’s reassuring to have something you can count on, and these annuities do their best to offer this peace of mind – at a cost, that is. Variable annuities are often criticized for their high built-in costs and surrender charges. In some cases, the extra expense can even diminish the tax benefits.
I liken an annuity contract to the deliberately over-engineered mouse trap that was a part of a popular board game of the same name from the ‘70’s. There are a lot of twists and turns before you get to the desired end result. The moral of this story is that because annuities are complex, you have to ask questions, and the questions you need to ask will likely depend on the type of annuity you are considering.
You can easily start with a few basic questions. Do you trust the insurance agent or financial advisor who is recommending an annuity product? Is the explanation they are giving you clear, concise and easy for you to understand? Have all costs of the annuity been made transparent to you? Once you get past these questions, take matters into your own hands. Research the type of annuity you are considering and read the contract. It won’t be easy to understand, and you may need some help translating the industry jargon. Finally, get a second opinion from another financial advisor. A second set of eyes may see something you missed.
Once you decide to buy, ask about the “free look” period during which time you can cancel the contract – free look periods are typically 10 days, sometimes up to 30. An annuity can play a role in your long-term investment plan, but make sure it’s one that is suitable based on your specific circumstances.