One sure sign of stock market volatility is a surge in ads touting the benefits of various annuities. Many of these pitches are akin to fear-mongering and play on the worries many investors have about the stock market in a shaky economic situation.
Don't Buy Annuities Based on Fear
Fear of the stock market is frequently used by annuity salespeople to entice investors to buy the products they are selling. Products such as indexed annuities and some varieties of fixed and variable annuities offer downside protection. As a result, the protection feature is sometimes used to prey on the fears of prospects, who are more often than not older clients.
Market corrections are a normal part of the investment cycle. A properly crafted investment portfolio should offer adequate cash or other low-risk, low-volatility investments to fund several years of cash flow needs without the retiree needing to dip into their stock portfolio.
It is incumbent upon financial advisors working with retirees to develop a plan to fund the client’s cash flow needs from all available retirement resources, including withdrawals from tax-deferred retirement accounts, taxable accounts, pensions, and Social Security benefits, as well as an annuity if the product is appropriate for the investor.
Considerations Before Buying
There is nothing wrong with annuities. However, problems can arise with the way they are often sold and with some of the specific products pushed by annuity salespeople. Below are a few factors to consider before buying an annuity product.
Make sure you understand all of the fees related to the product. Some variable annuities have ongoing annual expenses approaching 3%. To say this is outrageous would be an understatement. Expenses at these levels erode the amount available when it comes time to annuitize the product–receive a stream of payments–or take a lump-sum distribution.
A fixed annuity offering a substantially higher rate of interest than similar products should raise a red flag. Is the insurance company desperate to bring in premium dollars? Is the firm financially sound? The old adage “If it sounds too good to be true, it probably is” applies here.
Know who the insurance company is and research its financial viability. If something happens to the insurer, such as bankruptcy, it falls to the appropriate state department of insurance to cover you. There are generally limits on the amount guaranteed for annuities, so you will want to read the contract and make sure you understand all of the fine print.
Evaluate Surrender Penalties and Indexed Annuity Formulas
Annuities have underlying expenses called mortality and expense charges. This compensates the insurance company for the risks they bear should contract holders decide to annuitize. They have no control over how long the annuitant might live. Many annuities contain surrender charges that impose stiff penalties if you try to get out of the contract during the first few years. The surrender period can range from five-to-ten years or longer, depending upon the contract. Make sure you are aware of the length of the surrender period and the surrender charges.
Indexed annuities, often called equity-indexed annuities, offer limited upside participation in a stock market index like the S&P 500. They also offer downside protection in the form of some level of minimum guaranteed return. The sales pitches for indexed annuities vary from being a CD substitute to being a safe way to invest in the stock market. Make sure you understand the underlying formulas determining your return and any factors that might cause a change in the formula. Check out FINRA’s Investor Alert on indexed annuities as well.
Variable annuities generally have underlying sub-accounts that function like mutual funds. Living benefit riders have become a popular option or add-on to many contracts. A rider is an insurance policy or annuity provision that adds benefits to a policy or amends the terms to reduce or restrict coverage. If it's an added benefit, the rider will come with an additional fee.
Two popular riders are guaranteed minimum withdrawal benefits (GMWB) and guaranteed minimum income benefits (GMIB). A GMWB rider guarantees the return of the premium paid into the contract, regardless of the performance of the underlying investments via a series of periodic withdrawals. A GMIB rider guarantees the right to annuitize the contract with a specified minimum level of income regardless of the underlying investment performance.
Both types of riders entail added costs and require varying timeframes to be eligible for exercise and to recover the cost of the rider. These and similar contract options are major items that will be pushed by annuity salespeople during times of stock market turmoil.
Dinner Seminars and Scare Tactic Ads
The typical dinner seminar pitch is given to baby boomers and seniors in a particular demographic. The session might be run by a local registered representative, an insurance agent selling annuities, or in conjunction with an estate planning attorney. Radio ads for annuities generally tout how their product is an alternative to the volatility and risk of stocks. One local group in Chicago even used pro hall of fame footballer Mike Ditka to hawk its index annuity product. The ad ended with him saying, “Tell them da coach sent you!”
Rule Changes for Retirement Accounts
With the passage of the SECURE Act in 2019 by the U.S. Congress, rules changes regarding retirement accounts went into effect in 2020. The new rules impact annuities held within retirement accounts and employer-sponsored plans, such as 401(k)s. Please note that the changes listed here are not a comprehensive listing of all of the laws that went into effect due to the SECURE Act.
Previously, the IRA stretch provision allowed non-spousal IRA beneficiaries to take only the required minimum distributions each year from an inherited IRA. Under the SECURE Act, the stretch provision was eliminated. Beginning in 2020, non-spousal beneficiaries who inherit an IRA must withdraw all of the funds from the IRA account within ten years following the original owner's passing. Inherited retirement accounts that contain annuity products as investments are not exempt from the ruling. However, there are exceptions to the ten-year withdrawal rule for spouses as well as other special situations.
Also, if there's an annuity in your employer-sponsored retirement plan and you change jobs, the SECURE Act allows you to transfer the 401(k) annuity to your new employer's plan. However, it's important to note that changes were made regarding the legal liabilities or risks that insurance companies and annuity providers faced in years past. In other words, annuity owners may run into limitations when trying to sue an annuity provider if they default on the annuity payments.
Please consult a financial professional for a thorough review of all of the rule changes that went into effect as a result of the SECURE Act.
The Bottom Line
Annuities of various types can be a viable part of a well-constructed retirement income strategy. This is where a qualified financial advisor (versus a product salesperson) can help. He or she can determine if an annuity is a good fit in a client's plan and help find the most cost-effective product instead of using salesperson scare tactics.