I spoke to a reporter earlier this week who asked, “What’s the number one reason people buy annuities?” My answer, “because someone sold it to them”. When you slap a 7%-12% sales commission on any financial product, a hungry salesforce is going to find a way to sell it. Nobody wakes up in the morning searching for an annuity contract. They bought one because a salesperson contacted them and sold it. It’s a simple as that.
As I see it, there are three reasons to buy an annuity:
- You need a guaranteed income stream. At their core, annuities are insurance contracts designed to pay an annual income stream for a specified period of time, often for life. The concept is older than the stock market. In the late 17th century, an Italian banker living in France, developed a scheme that paid annual dividends to a pool of investors. As individuals in the group died, the surviving members received the deceased member’s share of dividends. The scheme was named a tontine, after the banker whose name was Lorenzo de Tonti. Modern insurance companies are following a similar structure by selling annuities pools of investors. Each individual stands to receive a higher lifetime income than they would from a standalone investment because some investors in the pool will die sooner, creating what are called “mortality credits” for the rest of the pool. For this reason, annuities could play a key role in solving the looming retirement crisis in America, but only if done without the conflicts of interest inherent in the sales commission distribution method.
- You need tax-deferred growth. Annuities allow for the deferral of tax on interest, dividends, and capital gains, but there are superior options to consider first. Retirement plans such as 401(k)s, IRAs, ROTH IRAs, Health Savings Accounts, and 529 plans offer tax-deferred growth at a lower cost and some even include the opportunity for tax-free withdrawals. Unless you are maxing out all of the above, you don’t need an annuity for tax-deferral. Withdrawals from annuities are taxed in a variety of ways, and none are appealing. If you do not annuitize, you must take out gains first and pay ordinary income tax. Only after you have withdrawn all gains can you withdraw your cost basis. If left to heirs, they are required to pay income tax on your gains with no step up in cost basis. If and only if you annuitize, you may use a ratio to claim a portion of your payment is cost basis and not taxed.
- You need asset protection. Depending on your state of residence, part or all of an annuity contract may be protected from creditors in the event of bankruptcy. Individuals working in high risk professions might find protection by placing assets in an annuity. I doubt 99% of annuity buyers have use for this reason to buy.
Among the many things that anger me about annuity sales is the placement of annuities in IRAs or worse, in retirement plans. I have yet to discover a valid reason for purchasing an annuity in an IRA, unless the buyer plans to immediately annuitize and has no savings outside the IRA with which to purchase an annuity. Take a look at the three reasons above, the IRA already provides tax-deferral and asset protection, so you are only left with guaranteed income. In my opinion, there is no benefit to owning an annuity in an IRA or retirement plan during the accumulation stage. It is nothing more than an expensive way to invest in stocks and bonds.
Another MAJOR pet peeve of mine is when an annuity salesman (or woman) claims the buyer is not paying the sales commission, but rather the insurance company pays it. And how do you think the insurance company pays it? With the buyer’s money! Making this claim should be a criminal offense. Don’t kid yourself, nothing is free.
Annuities are one of the most complicated financial products available. I keep a copy of The Advisor’s Guide to Annuities by John Olsen and Michael Kitces in my office for reference. Each time I encounter a client with an annuity, I learn something new. Most annuities are sold with incomplete information and misleading statements. While there is an opportunity to use annuities to solve problems, they usually do more harm than good under the current system. I’d like to see a complete overhaul of regulation of the insurance industry to ban sales commissions, but I’m pretty sure I won’t live to see that happen.
Annuities are Not Bought …. They’re Sold! (Tim Maurer)