Once upon a time, annuities were fairly simple products, on which the insurance company sought to make money on the interest rate spread between what it earned on bond-like investments, and the interest it paid out on life insurance contracts like annuity policies. In this way, business was a very bank-like proposition (and at least one author referred to insurance companies as the “the invisible bankers”) with the twist of having to manage life expectancy risk along with interest rates.
Annuities costs and complexity
These days, contracts and opportunities for insurance company profits have gotten a lot more complicated. Besides the spread, contracts can be loaded with a lot of other expensive features and riders from guaranteed income, refund, death benefit, market high water mark to investment reallocation and timing change privilege features.
These can be on top of the administrative, mortality, sub account (“mutual fund”), premium tax, and other charges found in popular variable annuity products.
Spotting annuities’ costs – prospectuses, specimen contracts and supplement disclosure
In many cases, total costs are astonishingly high, “hidden” in many different documents, and hard for consumers to figure out and put together. It can often be best to ask a knowledgeable advisor to examine a policy and report on total costs to save you effort or to make sure you catch everything.
This is something Camarda does often at no cost as part of its free portfolio stress test offer.
Estimating annuity commissions – the surrender charge rule of thumb
One rule of thumb, however, seems pretty accurate and is quite simple: you can usually infer the commission of the sales team pitching the annuity, and it is often close to the same percentage as the first year surrender charge. If the first year cost to get your money back is 8% (and it gets way worse than this), odds are good the agent team made the same. That’s some $80,000 per million in annuity premium, folks, which is pretty much a transaction fee without any real promise of ongoing service or investment management.
Annuities’ guarantees – much weaker than FDIC
At the end of the day, annuity guarantees are pretty much only as good as the insurance company’s ability and willingness to pay your money back.
While there are state guarantee funds to backstop failing insurance companies, these are nowhere near as robust as FDIC and should not be considered absolute guarantees.
If the insurer goes belly up, it may be years before you get your money. You may not get all of it. If the fund goes dry, there is no telling what might happen.
Warnings on life insurance and annuities guarantees – you could lose all your money
So be warned. For this reason, insurance company ratings (similar to the bond ratings that help you gauge how likely you are to get your money back) are critical.
Unlike junk bonds (junk because the promise of bond repayment is questionable) annuities don’t trade on a marketplace, and can be very illiquid considering surrender charges and redemption issues if a company gets into trouble.
My suggestion is to stick with top-rated companies and also stick to those you expect to remain top rated over the period before which they will hold your money, perhaps as long as you live, or longer.
Remember, things can change, and a company sporting top ratings now may be a completely different animal later in your life. The entry of private equity companies into the annuity space has changed the chessboard, making many annuities riskier and more complicated.
Low rated annuity companies – higher potential returns, more risk
The lure of lower rated companies can be high, since they will often offer consumers tempting features like above-market bonuses and more lucrative return formulas.
Remember that they will offer better terms because they may have to get investors to overlook the higher risk of defaults, and will usually spin their ratings story as positively as they can.
Don’t forget that old “let’s put some lipstick on this pig” commercial.
Incentives to annuity salespeople to push riskier annuities
Remember, that lower rated companies will often offer higher commissions, trips, and production bonuses to agents to get them to overcome their aversion, and that big payouts can make for a powerful sales pitch. If you choose to use a lower-rated company, be smart, and only invest on the same limited basis you would consider for any other higher risk investment.