Q. My wife and I will be meeting with our financial advisor in a few weeks. He is suggesting we put some money in an annuity. The money will be a rollover from my wife’s company’s pension plan. What information should we have before meeting with the advisor? We both are retired.
A. Annuities are always a sticky topic.
They’re often oversold to investors who don’t really need them – by salespeople who want to earn a big commission.
But when carefully chosen, annuities can be an essential part of a comprehensive retirement plan. They can help protect you against stock market volatility and outliving your assets.
However, with this protection comes additional costs, fees and restrictions which clients must review and fully understand before considering an annuity purchase, said Matthew DeFelice, a certified financial planner with U.S. Financial Services in Fairfield.
“As a customer, you should have a list of questions ready to ask your advisor when you meet so that you can make an informed decision,” DeFelice said.
He offered some examples:
First, ask what type of annuity you are being offered.
“In the simplest terms, an annuity contract is essentially a way of converting an asset into a stream of income,” DeFelice said. “An investor gives money to an insurance company, and in exchange the insurance company agrees to provide the investor – or the investor and their spouse – with an income stream that they cannot outlive.”
The lifelong income stream can either begin today, which is known as an “immediate annuity,” or at some point in the future, known as “deferred annuity,” he said.
DeFelice said immediate annuities are contracts in which the buyer pays a set premium in return for a promised annual payment for as long as they live. The amount of income is usually based on the age of the purchaser when the annuity begins and actuarial assumptions about the individual’s life expectancy, he said
Deferred annuities credit accounts annually with a certain growth rate.
“The crediting rate is based on either a fixed amount; equity and bond performance; or a combination of the two,” he said. “Deferred annuity contracts do not provide an immediate income stream but instead are a long-term tax-deferred investment which can eventually provide a life-long income stream.”
Deferred annuities typically fall into three categories, DeFelice said:
Fixed annuity: You lock in a guaranteed rate of return for periods ranging from one year to ten years. Rates can fluctuate but will never drop below your guaranteed rate. You won’t lose money, but you won’t have the potential for growth you’d get by investing in stocks or stock funds.
Variable annuity: The money is invested in accounts similar to mutual funds. Just like investing in a regular mutual fund, your account value will fluctuate with the ups and downs of the stock market and unlike a fixed annuity your returns will vary. However, most variable annuity providers offer optional income riders that you can add to the contract called “living benefits”. Living benefits can provide guarantees on both a minimum growth of your account value and how much income you can withdraw from the contract down the road. These living benefit riders are what provide lifetime income in a variable annuity, but they come with an added fee.
Equity-indexed annuity: Like a fixed annuity, you get a guaranteed rate and fixed payments with this product. But it provides more opportunity for growth because the annual crediting rate is tied to an index such as the S&P 500. Most equity-indexed annuities will guarantee you won’t suffer any losses in the down years, but will also place a cap on the upside in positive years.
Your next question: What exactly are the fees associated with the annuity?
“While immediate, fixed and equity-indexed annuities usually come with lower costs, deferred variable annuity fees can easily total 3 percent a year or more,” DeFelice said. “You need to understand what you are being charged and how the deduction of annuity fees affects your account value and your living benefits.”
On average, he said, some typical deferred variable annuity fees include:
A. Mortality and Expense fees (M&E): 1.25%-1.40% – these fees are typically charged by the insurance company to compensate for the death benefit payout risks if the contract owner passes away.
B. Administrative Fees: 0.10% – 0.30% – This fee covers reporting, generating product illustrations, online security and account access.
C. Fees for optional living benefit riders or insurance guarantees: 1.00-1.50% – Income features guarantee that a cash flow stream from the contract will continue uninterrupted regardless of market fluctuation.
D. Investment management fees charged for the underlying funds inside the annuity: 0.75-1.25% – These are annual management fees similar to what you would pay in a mutual fund.
E. Surrender Fees which may be charged for closing out an annuity too soon – These can typically start in the range of 8.00%-10.00% and decrease each year until they reach zero. Back-end surrender periods can be 4, 8, 10, or even up to 15 years with some products.
Then, ask: Will the insurance company offering the annuity be able to make good on its promises?
It may seem obvious, but when purchasing an annuity, it needs to be issued by a financially-stable insurance carrier, DeFelice said.
“Credit ratings matter,” he said. “Consumers have little other objective information to determine the likelihood they will receive their promised benefit in the future.”
Next, be sure to ask: What are the guaranteed retirement income benefits?
DeFelice said deferred annuity products often guarantee the contract owner can withdraw a minimum percentage from an annuity contact.
“But as with anything, the devil is in the details and not all living benefits are created equal,” he said. “You need to understand exactly how the guaranteed income you are paying the extra fees for will work in both good and bad market conditions.”
Finally, ask: How will the annuity perform in both good and bad market conditions?
This question is much trickier than it may appear, DeFelice said.
Annuity contract net return calculations can be very complicated and are rarely straightforward. Be sure to consider all fees, and in the case of equity index annuities, the formulas that might be applied to calculate total return, he said.
You should be able to review what hypothetically happens to the contract value under historic market performance and “worst-case” scenarios, DeFelice said. Your actual return over the long run will likely fall somewhere in between the two.
Annuities are obviously complex financial products, and whether or not they are an appropriate investment for you will depend on many factors – including your overall asset levels and how much guaranteed income you actually need in retirement, he said.
“For example, if you happen to have a pension and all of your basic, fixed living expenses are covered by the pension and Social Security, you may not need to add an annuity to the mix,” he said. “If that is not the case, the right annuity may add an element of stability and security to your retirement distribution planning.”
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