The Investment Scientist

Why A Fixed Rate Annuity Is Not A Savings Account

Posted on: June 13, 2014

images-65 A client of mine bought a fixed rate annuity a few years ago. She was told by the agent that it’s just like a savings account, only with a higher interest rate of 3%.

Recently, we took the money out in favor of a better investment, and boy was she in for a shock! There was a $17k surrender charge and nearly $3.6k in tax withholdings. All the interest she supposedly earned in the annuity went to the surrender charges, and now she has to pay income taxes on that interest!

Here is why a fixed rate annuity is nothing like a savings account.

1. A savings account is FDIC guaranteed, in other words, it has the full faith and credit of the US government behind it. A fixed rate annuity is NOT FDIC guaranteed, it only has the credit of the issuing company behind it. Think AIG!

2. A savings account will never charge you an arm and a leg for taking your money out, but a fixed rate annuity will, if it is so written in the annuity contract you didn’t read.

Buying a fixed rate annuity is like lending your money to the insurance company. If you didn’t know it yet, insurance companies are just plain old corporations, and the prevailing interest rate for lending to corporations is about 5.5%. Think on that!

So, with an annuity you get struck twice, first with the interest rate, then with the surrender charge. I think it’s safe to call a Fixed Rate Annuity a bad investment. Wouldn’t you?

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10 Responses to "Why A Fixed Rate Annuity Is Not A Savings Account"

The final sentence illustrates part of the problem. A fixed annuity is not an investment, it is a savings and income instrument. Although not FDIC insured every fixed annuity contractually guarantees that neither principal nor interest can be lost due to investment risk and every fixed annuity is backed by the insurance company and a state guarantee fund (for at least $100,000). A fixed annuity is not a savings account, but may be viewed more akin to a certificate of deposit because both have penalties for early withdrawal. At 3% she was earning 6 TIMES the current rate paid on bank savings (bankrate), her money was protected from investment loss, she had control over when to pay taxes on the interest, and if she had left the annuity alone until the end of the term – which apparently was her intent – she would have incurred no penalties. Instead, the actions of this advisor took away those guarantees, forced her to incur taxes and caused her to pay a $17k surrender charge. Finally, I’m not surprised the client was shocked by the advisor’s actions.

Jack, you are wrong on that. Buying a fixed rate annuity say like lending money to one corporation. When corporations borrow money from you, they all guarantee to pay it back as long as they are not bankrupt. There is no more magic from an insurance company’s guarantee. If you buy a bond mutual fund, you will get much higher return with less risk since there it is diversified.

Better yet, if you buy a muni bond fund, you will still get a higher return than 3% without taxes and even less risk since it’s guaranteed by state governments.

Back to CD, I have never heard of a CD that would stick you with a 7% surrender charges.

The municipal bond is an investment, a fixed annuity is not. Unlike your bond issuers the insurance company is required to keep statutory minimum reserves. Unlike your bonds every fixed annuity is backed by a state guaranty association that covers principal and deferred interest for at least $100,000 – 38 states provide a minimum of $250,000 – if the carrier goes under. Regarding bonds, a study I did a few years ago (Milliman, Best) showed from 92-08 the returns on taxable bonds and fixed annuities were roughly the same, although the bonds carried the risk of investment loss and should have returned more. As I’ve written in the past, liquidity costs are always a comparison. If the woman had placed her money in 1 yr CDs 3 years ago she’d have earned 1.2% in total (bankrate). If she was in a 3% annuity she earned 9.3%. Even after your 7% penalty the woman still has 2.3% – a percent more than the CD.
The real question is fiduciary/suitability related. Did this women say “please cash in my annuity guaranteeing a 3% return and no market risk, cause me to lose $17k that I could have avoided, and place me in a non-guaranteed place at the top of a bull market in a rising interest rate environment.” If her goal was a higher return and she accepts the higher risk then the transfer would seem to be suitable, if not, well… (and the second part of your statement on municipal bonds is largely incorrect).

I’m unclear if you are against all fixed annuities or just this one. Surely, not all fixed annuities are bad.

In addition, in what world are you finding Corporate bonds with similar credit quality and liquidity paying 5.5%?

I’m not a fan of surrender charges, but understand why they might be used (if used properly), but you fail to mention the risk to principal in your own strategy.

I personally use fixed annuities when appropriate and have found them to be a good place to put money in the right situation.

I disagree with your post.

Scott, the only annuity that makes sense to me is immediate annuity, which insures against longevity risk. All other annuities are just indirect investments that add another layer of costs.

Remember, annuities are supposed to be a insurance product, but now they are sold like an investment with a magical guarantee or a saving account with a high interest rate. Both are very misleading.

I fail to see why owning an “indirect investment” with an added “layer of costs” is wrong if both add value. I could care less about what an annuity is “supposed” to be, I care about how a particular product can increase my clients return or reduce their risk (or some combination of both). Completely excluding annuities is not how a fiduciary works.

I have clients who benefit from both the structure and higher interest rate. I don’t sell annuities and can agree that many insurance agents do “sell” annuities and attempt to make them something they are not.

In this environment of low rates, it makes no sense to be to exclude an entire class of financial products when they could add value.

I’m not sure why representing a fixed annuity as a savings option is misleading, I don’t know how else to describe it – the primary feature is exactly that – savings.

I don’t think all annuities are great – an annuity is just a structure – it’s the product within that structure that is either good or bad (or good or bad for a particular client).

Scott, it is simple arithmetic: if you increase costs, you reduce returns.

What Michael does not mention (possibly because a fish does not think about the water in which he swims) is that the return on annuities comes from insurance companies investing money in other businesses via stocks and bonds. Any annuity’s return is not a magic source of money coming from nothing. The insurance company guarantees a minimum return every year by making *more* money in some years, less in others, giving out an average but taking a rather large commission in the process. While this may be a benefit for immediate annuities where the client depends upon a steady and “safe” income, it’s fakery when the time for use is decades away. Some fixed rate annuity advertising compares their returns to low earning investments like savings accounts or municipal bonds (to reassure their clients by making it seem like a safe bet as well as lowering their expectations), but their actual income comes from stocks and corporate bonds. Variable annuities compare themselves to stock market returns, though usually “S&P500″ returns without dividends. Either way, the insurance company lowers expectations but makes the full stock & bond returns including dividends and gives their client a small slice of the total. After all fees and taxes, one calculation I saw was in the range of 25-30% of total invested return. That’s no bargain. In my not so humble opinion, any investment adviser who collects a commission for steering a client to a deferred annuity is engaging in a conflict of interest and giving a bad deal. An investment adviser who steers a client to a deferred annuity without a financial conflict is still not doing their job by letting the client know he/she could be claiming the full return, possibly 3-4x more gain, also a bad deal. When a client has a 20-30 year time frame, stock market fluctuations even out over time, so neither the insurance company nor the individual are taking much of as risk investing in the stock market directly. (Which is how the insurance company knows they can make the promises in their contracts.) Where does the client benefit from this arrangement, aside from making a deferred annuity look like an illusory lower “risk” investment in exchange for real cash and a real, major loss of return over time?

Jerry, well said!

Michael, thank you. If you think it would be helpful to others, then you are welcome to adjust it and maybe even use it as a “guest” blog post. It seems to fit into your current annuity series. (I hope this suggestion is not rude.)

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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