Q&A: Annuities have indirect costs

Dear Liz: Thank for your right-on reply to the reader who claimed that fixed and indexed annuities were available at no cost to investors. I am so tired of hearing from agents and investors that their annuity is great and does not have fees!

Answer: Insurance companies aren’t charities providing investments at no cost. They’re businesses that have to keep the lights on and pay the people who sell their products. With fixed and indexed annuities, the cost is built into the interest rate spread, which is the difference between what the insurer earns on your money and what it pays into your account. The investor pays an indirect cost, rather than a direct cost that’s explicitly disclosed.

Q&A: Annuities and fees

Dear Liz: I must object to a point you made in a recent column. You wrote: “…Also, annuities often have high fees, so you’d need to shop carefully and understand how the surrender charges work.” To write “…annuities often have high fees” is misleading, because there are annuities that don’t have fees, such as fixed annuities and indexed annuities. Coupling that phrase about fees with the admonition “you’d need to shop carefully and understand how the surrender charges work” is also a disservice to the public. Of course, an investor has to understand surrender charges! Just like if they try to end a bank CD too soon, there’s a penalty, or if they try to get out of a real estate deal incorrectly, or if they commit some other kind of breach of contract. That doesn’t mean that annuities are bad investments, especially when their principal is guaranteed, and no fees to pay.

Answer: Thanks for bringing up two areas of confusion that are actually linked.

All investments have costs. Many, including mutual funds and variable annuities, explicitly state their fees. With fixed and indexed annuities, the cost isn’t disclosed. Instead, it’s built into the interest rate spread — the difference between what the insurer earns on your money and what it pays into your account, said financial planner Michael Kitces, partner and director of financial planning research at Pinnacle Advisory Group in Columbia, Md.

“In other words, if the annuity company pays 2.5% on its annuity, it likely earned closer to 3% or 3.5% in the first place,” Kitces said. The insurer keeps the remainder to recover commissions paid to the insurance agent and the annuity’s own profit margins, he said.

Indexed annuities are a little more complicated. These promise investors they will get a certain portion of the return earned by some market benchmark while protecting them from market losses. The insurers use the spread to cover their overhead costs, profits and commissions. But instead of paying the remaining yield into your account, insurers use the money to purchase options that provide the promised participation rate in the index, said Kitces, who writes the Nerd’s Eye View blog at kitces.com.

Either way, surrender charges encourage people to stay invested long enough for the insurance company to get back enough money from the interest rate spread to cover the cost of commissions. If people need their money during the first few years, the surrender charge they pay is designed to make up the difference between what the insurer paid out and what it has received from the yield spread. Surrender charges are typically around 7% to 9% and may persist for seven or more years, although the penalty declines over time.

You’ve heard that “there’s no such thing as a free lunch.” Investors need to understand that they’re paying a price for their investments, even if they can’t see the money directly coming out of their pockets. Costs are a drag on investor returns and how big their portfolios can grow. That’s why it’s important to minimize those costs. When insurers don’t disclose the costs, it’s hard to know how much you’re giving up compared to what you could earn from another investment.

Friday’s need-to-know money news

bankruptcy_formToday’s top story: How to find a bankruptcy attorney. Also in the news: What consumers need to know about annuities, signs you need a new financial advisor, and what millennials should know about life insurance.

How to Find a Bankruptcy Attorney
Making the right selection.

What Consumers Need to Know About Annuities
Combining life insurance with investment.

7 Signs You Need a New Financial Advisor
When it’s time to go in another direction.

The First 4 Things Millennials Should Know About Life Insurance
Thinking long term.

Thursday’s need-to-know money news

Zemanta Related Posts ThumbnailToday’s top story: Why applying for a credit card can hurt your credit score. Also in the news: Things on your credit report that might scare off lenders, why couples don’t talk enough about retirement planning, and when is the right time to consider annuities.

Here’s Why Applying for a Credit Card Hurts Your Credit Score
You may want to think twice before applying.

5 Things on Your Credit Report That Might Scare a Lender
Things to watch out for.

Study: Couples Don’t Talk Enough About Retirement Plans
Huge mistake.

When to Consider Annuities If You Want to Safeguard Your Retirement
Making the right decision.

Wednesday’s need-to-know money news

321562-data-breachesToday’s top story: How often you need to change your passwords. Also in the news: The truth about life insurance, annuities, and financial aid, how to catch up on your retirement savings after 50, and the four necessities for a successful retirement.

How Often Should You Change Your Passwords?
More often than you think.

Consumers Beware: The Truth About Life Insurance, Annuities And College Financial Aid
How they all tie together.

Over Age 50? How to Catch Up on Retirement Savings
There’s still time.

4 Necessities for a Successful Retirement
It takes more than just money.

A Prescription for Financial Wellness
Getting yourself financially healthy.

Wednesday’s need-to-know money news

847_interestrates1Today’s top story: The importance of understanding interest rates. Also in the news: Protecting your identity while shopping online, the pros and cons of retirement annuities, and what you should ask before paying your medical bills.

Misunderstood Money Math: Why Interest Matters More Than You Think
Understanding the complicated world of interest rates.

8 Ways to Protect Your Identity While Online Shopping
While you’re shopping for deals, hackers are shopping for you.

Who Benefits From Retirement Annuities
The pros and cons of a retirement annuity.

6 Questions You Should Ask Before Paying Any Medical Bill
Analyze every single penny.

The Right Way to Tap Your IRA in Retirement
RMDs can trip you up.

Get second opinion before buying cash-value insurance

Dear Liz: I think you missed one of the possibilities when a reader wrote to you about a pitch he received from an insurance salesman. The salesman wanted the reader to stop funding his 401(k) and instead invest in a contract that would guarantee his principal but cap his returns in any given year. You thought the salesman was pitching an equity indexed annuity, but it’s possible he was promoting an indexed universal life policy, which would offer the same guarantees of principal and offer tax-free loans.

Answer: You may be correct — in which case the product being pitched is just as unlikely to be a good fit for the 61-year-old reader as an equity indexed annuity.

Cash-value life insurance policies typically have high expenses and make sense only when there’s a permanent need for life insurance. If the reader doesn’t have people who are financially dependent on him, he may not need life insurance at all.

Furthermore, the “lapse rate” for cash-value life insurance policies tends to be high, which means many people stop paying the costly premiums long before they accumulate any cash value that can be tapped.

Before you invest in any annuity or life insurance product, get an independent second opinion. One way is to run the product past a fee-only financial planner, who should be able to analyze the product and advise you of options that may be a better fit for your situation. If you just want a detailed analysis of the policy itself, you can pay $100 to EvaluateLifeInsurance.org, which is run by former state insurance commissioner James Hunt.

Insurance better than 401(k)?

Dear Liz: Recently, someone from an insurance company proposed that I stop investing through my 401(k) at work and instead invest in his insurance company contract with after-tax dollars. He claims the funds would be guaranteed so that I would never lose principal, although there would be a cap on how much I could make in any given year. His claim is that it is better to forgo the tax deduction I would get from my 401(k) contributions so that I can take the money out of this contract tax-free in 20 or 30 years. I think I am too old for this program (I am 61 now) but I thought it might be appropriate for my daughter when she enters the workforce in a few years.

Answer: You may have been pitched an equity-indexed annuity. These are extremely complex investments that should not be purchased from someone who misrepresents how they work and who encourages you to forgo better methods of saving for retirement.

Withdrawals from annuities are not tax-free. You would not have to pay income tax on the portion of the withdrawal that represents your initial contributions, but any gain would be taxable at regular income tax rates.

Furthermore, most people fall into a lower tax bracket in retirement. That makes the tax break offered by 401(k) contributions especially valuable, because you’re getting the deduction when your tax rate is higher and paying the tax when your rate is lower.

The Financial Industry Regulatory Authority, which regulates securities firms, has warned that most investors consider equity-indexed annuities and other annuity products “only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.”

Even then, you probably have better ways to save. Contributions to a Roth IRA would not be tax-deductible, but withdrawals in retirement would be tax-free. If you’re able to save still more, you could contribute to a regular, taxable brokerage account and hold your investments at least one year to qualify for long-term capital gains rates, which are lower than regular income tax rates.

The other possibility is that the insurance salesman was pitching a life insurance policy that would allow you to take out a tax-free loan. Although life insurance is sometimes pitched as a retirement savings vehicle, it’s an expensive way to go. In general, you should buy life insurance only if you need life insurance. To help ensure a policy is suitable for your situation, you should take it to a fee-only financial planner—one who does not make commissions from selling investments–for review.

In any case, you don’t want to do business with someone suggests you stop funding your workplace retirement plan, and you certainly don’t want to refer him to family members. What you should do instead is pick up the phone and report him to your state insurance department.

Should you take a lump sum now or an annuity check later?

Dear Liz: My former employer is offering the one-time opportunity to receive the value of my pension benefit as a lump-sum payment. The other option is to leave the money where it is and get a guaranteed monthly check from a single life annuity when I reach retirement age. I am 40 and single, and I have been investing regularly in a 401(k) since graduating from college. I have minimal debt aside from a car payment. When does it make financial sense to take a lump sum now instead of an annuity check later?

Answer: Theoretically, you often could do better taking a lump sum and investing it rather than waiting for a payoff in retirement. That assumes that you invest wisely, that the markets cooperate, that you don’t pay too much in investing expenses and that you don’t do anything foolish, like raid the funds early.

That’s assuming a lot. Another factor to consider is that the annuity is designed to continue until you die. It’s a kind of “longevity insurance” that can help you pay your bills if you live a long life.

Some financial advisors will encourage you to take the lump sum, since they may be paid more if you invest it with them. Consider consulting instead a fee-only financial planner who charges by the hour — in other words, someone who doesn’t have a dog in this particular fight. The planner can walk you through the math of comparing a lump sum to a later annuity and help you understand the consequences of both paths. This is a big enough decision that it’s worth paying a few hundred bucks to get some expert advice.