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Smart Investing Newsletter Archive

The Dangers of Annuities


Tuesday, June 27th, 2017

Annuities have been bought by many people not because they are a great investment but because they were sold by great sales people. That is one reason I am so pleased to see the new fiduciary rule which imposes a fiduciary standard on investments purchased for retirement accounts. Hopefully, the next step will include all accounts, not solely retirement accounts, to meet a fiduciary standard. The fiduciary standard means advisors must do what is in the client’s best interest rather than what is suitable. A suitable investment can have the highest fees and worst performance, but if it is suitable then it is deemed an alright investment. The rules passed by the Department of Labor in early June will fully go into effect in 2018, but their impact is already being felt.

Sales of annuities were down 8% in 2016 and for the first quarter of 2017 they have experienced an 18% decline. What I'm even more pleased to see is high fee variable annuity sales fell 22% in 2016 and continued to decline in 2017, as they tumbled another 10% in the first quarter. This was the lowest sales level since 1998. Analysts are also predicting the decline will continue and worsen in 2017 and 2018. I say worsen as a good thing because consumers will benefit and insurance companies and agencies charging excessively high commissions will no longer be able to do so. You may find some of those agents on the used car lots trying to make money selling people bad cars.

But don't get too excited, just when you think it is safe, the industry has created a new category of annuities called Buffer Annuities, these are the new indexed annuities. Indexed annuities were sold as a stock market alternative with no risk of principal. Insurance agents could make as much as an 8 to 10% commission and investors’ money could be tied up for 10 years or perhaps longer. The way they function is the longer the surrender charge, the bigger the sales agent commission. What a great thing for the consumer? It is no wonder the average investor does so poorly over the long-term.

People do not comprehend how indexed annuities work and the reason their performance will never come close to a good investment portfolio filled with fundamentally strong companies. Now yes, you will have volatility in your portfolio and yes, you will not see that in your indexed annuity, but would you rather have an 8% return with volatility over the long term or a 4% return with no volatility over the long term. I hope many of you would like to attain that 8% return.

Indexed annuities can provide low volatility because they invest 95% to as much as 99% in fixed investments and the rest is invested in derivatives which are typically options to mimic a certain index’s performance.

So how in the world is an investor supposed to get a good return over the next 10 years using an indexed annuity when the sales agent received a 10% commission? Most of your money is invested in mid-term bonds and the rest into high-risk derivatives. Therefore, some of these indexed annuity's only average a 4% annual return over 7 to 10 years.

One well-known company, AXA has a 20% cap on the downside. This means with anything greater than 20% you absorb the loss; however, the upside is capped for six years at a total return of 37%. If you think that doesn't appear to be a very good return over six years, I agree with you. That is approximately a 5% per year compounded return and remember that is the best return you can expect.

The insurance industry that sells these high commission products is now starting to look at the investment advisory industry as a place to make up their lost sales. It would make no sense for a reputable investment advisor to invest some or all your money in an annuity using your advisory account. The advisor would be locking your funds into an investment for 5 to 10 years and charge you a management fee for doing nothing. This makes no sense and reputable advisers won't do it, but some will, investors be aware.

If you are in the process of being sold an annuity, you must consider that if this product is not in the best interest of your retirement money, why would it be in the best interest of your non-retirement money?

Another reason why fixed or indexed annuities do not make sense in advisory accounts is the advisors can invest clients’ accounts into brokered CDs and search for the highest yielding CDs with different maturity dates with no surrender charges or high fees.

I for one am happy to see the improvements in the industry. Throughout my career I have strived to make my clients money and charge reasonable fees by doing extensive research and building a portfolio that is not matched by any.