3 Risks of Investing in Annuities

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Getty ImagesThe money you put in an annuity typically isn't available for emergencies or bequests.
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Investing can be scary, especially in the short term. When you retire, it's hard to watch the value of your lifetime of savings fluctuate as financial markets bounce up and down. Fear is a powerful sales tool.

Immediate annuities are an insurance product that prevents you from losing money and offers the benefit of guaranteed payments. However, there is a catch with those guarantees. Many annuities aren't guaranteed to keep up with inflation, so the purchasing power of those guaranteed payments could decline over time. Tying up a significant portion of your money in an annuity also takes away some of your financial options and flexibility, because you can't always get the money back out easily. And some annuities are outright expensive.

Here are some of the issues you could face if you invest your retirement savings in an immediate annuity.

Inflation risk. Inflation has been artificially low for years due to manipulation by central banks and the slow growth patterns of the economy. As a result, many people have forgotten how inflation can reduce the buying power of fixed income payments and guaranteed rates of return.

Inflation is a normal occurrence as the cost of goods and services increase over time. Back in the late 1970s and early 1980s, inflation hit double digits.

A diversified investment portfolio has the ability to grow and provide a return above inflation. However, if you purchase an annuity in today's low interest rate environment, you could find yourself in a situation where your "guaranteed" rate of return isn't keeping pace with the rising costs of goods.

It wasn't too long ago that the average rate of return on savings accounts insured by the Federal Deposit Insurance Corp. exceeded 4 percent at your local bank. With the Federal Reserve planning to increase interest rates, the risk of inflation should be factored in to any annuity purchase.

Loss of flexibility. Putting a portion of your savings into an annuity means that it won't be available for current expenses or emergencies. Here's how you limit your options when you purchase a guaranteed rate of return from an insurance company:
  1. Penalties. If you change your mind or incur an emergency expense and want to pull your money out of an annuity, you're probably going to face surrender charges. You could find yourself in the unfortunate situation of being subjected to surrender charges that exceed 10 percent. The insurance company is able to provide you with a guaranteed return due to the restrictive nature of the investment that makes it expensive if you want to withdraw your money early.
  2. No legacy options. Fixed annuities provide guaranteed payments during your lifetime. But when you pass away the payments typically cease, and your initial investment is retained by the insurance company. In some cases you can buy additional insurance riders that act as life insurance and repay the principal if you die unexpectedly. However, this additional protection has an extra cost that can add to the annual fees and ultimately lower the return or guaranteed payment, which is why you likely purchased the annuity to begin with.
  3. Limitations. Some annuities are designed to mimic the behavior of the stock market. Equity-indexed annuities supposedly make money like the stock market without the risk of losing principle. However, your participation in the returns of equity markets is capped or restricted. It varies by policy, but the limits typically kick in around 8 percent. That may sound generous, but consider how much money you would have been shorted in 2013 when the S&P 500 returned 32 percent. Make sure you read all disclosures and fine print before investing in an equity-indexed annuity.
High fees and commissions. Insurance products have multiple layers of fees. These can include mortality expenses, administrative costs and sales commissions. The fees can be steep. The Securities and Exchange Commission estimates that the average mortality expense is around 1.25 percent, and sales commissions are typically 5 to 6 percent.

Annuities are complicated insurance products with strict limitations on the guaranteed income. Given the current low interest rates and potential for increasing inflation, annuities certainly won't be a good fit for everyone. Make sure the broker, agent or adviser you are working with truly understands your situation, needs and all of the investments available to you -- not just the products that are the most lucrative for them.

Some tell-tale signs that you may need to seek a second opinion are:
  • A persistent recommendation of one product without clearly articulating (in easy to understand language) why it's the best fit for you.
  • A limited knowledge of the entire realm of possible solutions, such as fixed versus variable products and immediate versus deferred annuities.
  • Recommendations that don't make sense or that you can't easily understand.
  • Offering insurance solutions for non-insurance problems, such as saving for college, paying off debt or emergency reserves.
Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show."
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