A Balanced Portfolio to Avoid (I): Annuities Are Not Without Risk
Posted on: April 26, 2011
I recently met an entrepreneur friend of mine. I was pleasantly surprised to learn that he had sold his business and was now looking forward to retirement. He has about $1mm in his 401k plan. As any shameless financial advisor would do, I asked him if he had someone helping him manage his money.
“As a matter of fact, yes!” he answered. “A friend of mine is also a financial advisor, and he helped me create a balanced portfolio.”
He related that “50% of the money will be in safe investment—a (deferred) annuity that has a guaranteed yield of 5%; the other 50% will be in alternative investments for higher performance.”
To say that I was flabbergasted is a serious understatement. With a friend like that, who needs enemies?
Annuities are often sold as a secure investment with a guarantee, just like CDs, except with higher yields. However, not all guarantees are the same. CDs are guaranteed by the full faith and credit of the US government; annuities are guaranteed by the words of insurance companies, e.g., AIG. Last time I checked, insurance companies didn’t own the franchise to print dollars, yet. Their guarantees are only as good as their solvency. And they do go bankrupt.
On top of that, deferred annuities that are heavily pushed by agents usually have a long surrender period, some as long as 20 years. Taking money out before the surrender period ends usually means paying a substantial surrender charge. Just imagine a 65-year-old retiree who has to wait until 85 before he can use his retirement money without penalty. The longer the surrender period, the higher the commission is for the agent. Guess what most agents would do.
The attractive guaranteed yield of 5%, which undoubtedly is the primary selling point of the annuity, is not what it’s cracked up to be. Buried somewhere deep in the contract, there is a clause that the guaranteed yield is for a fixed period, such as one month. This is a common trick used by insurance companies. The attractive yield is displayed prominently, while the qualifying clause is hidden like King Tut’s tomb.
In summary, annuities are not without risks. People who buy annuities expose themselves to three serious risks:
- Credit risk of the issuing companies;
- Liquidity risk, because they can’t use the money when they need it most; and
- Asymmetric information risk, because the annuity contracts are written by the insurance companies in a way that requires an actuary and an attorney working together to understand.
Annuities are NOT safe investments!
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8 Responses to "A Balanced Portfolio to Avoid (I): Annuities Are Not Without Risk"
[…] My friend is a savvy businessman. However, like most Americans, he has a misconception: he thinks financial advisors are legally bound to put clients’ interests first. This can not be further from the truth. Everybody and his grandma can be a “financial advisor.” Unlike being a “physician”, there are neither legal requirements no educational qualifications. Whether a certain financial advisor is bounded legally to act in his client’s best interests all depends on his true profession. Here is an ad hoc summary: […]
May 18, 2011 at 7:38 pm
Eric, I observe the fiduciary standard in my wealth management practice. I do that by avoiding all forms and appearances of conflict of interest, including not accepting any third party payments (such as commissions, referral fees, etc.)
May 28, 2011 at 6:14 pm
Your bias against annuities is sticking out — way out. First of all, show me any annuity from a reputable insurance company that has 20 years of surrender penalties. Second, the 5% guaranteed rate is not for month, one year or otherwise, it is the rate guaranteed IF the annuity owner takes a lifetime income rather than a lump-sum settlement. Third, can you name me one annuity holder that lost money because the insurance carrier went tits up financially? Michael there are none — yes sometimes the money was not available for a couple years, but losses NO. If you are going to criticize a competing product Michael, at least take the time to understand it. What a wing-nut you must be.
May 28, 2011 at 7:39 pm
1. 20 year lockup may be hard to find among reputable insurance companies – some of them would have gone belly up already if not for government bailout – 10 year lockup is common place.
2. 5% can be referred to a number of things. Most of the time, buyers are very confused what it is referred to. The variable annuity contract I examined has a fixed account, if the money is put in the fixed account (as opposed to the variable sub-accounts,) it will earned a guaranteed fixed rate of 5.75%, displayed in bold upfront. A few pages deeper into the contract, it is disclosed the fixed rate is 1.75% after the first month. My client did not read the whole contract, he thought the 5.75% is guaranteed forever, but once pointed out to him, he felt cheated.
3. As to the example you mentioned where the owner takes a life time income. I happened to have examined a contract with that feature as well, in fact, it has better feature, if the owner hold the annuity for 10 years, the guaranteed amount would double. I wrote up the example here: https://investment-fiduciary.com/2011/03/10/variable-annuity-guarantees/
4. I am not criticizing the whole product line. I am a fan of fixed immediate annuities. For some of my less well-to-do clients, I help them ladder into those annuities. This product pays much smaller commissions so no salesman in the right mind would promote it. But I don’t earn commissions, so I can do what’s right for my clients, not what earn me the most commissions.
5. With regard to your last comment, I confess I go nut when I see the sophisticated financial industry taking advantage of ordinary hardworking people.
6. Lastly may I ask, do you happen to sell life insurance and annuities for living?
The Investment Scientist 
April 26, 2011 at 1:57 pm
Excellent, and very informative article. Thanks.