Annuities: Appropriate Investments?

Many investors have got into trouble by investing in annuities in recent years. The right annuities can make appropriate investments for some people. However, the state of the financial markets in the early 2000s caused many brokers to push less stable annuities onto people for whom they were inappropriate.

The annuity problem can be traced at least partly to high broker commissions. Brokers typically receive a 2-3% commission when they sell a mutual fund. With annuities, the commission is as high as 7-10%. The broker also gets a trailer fee over time without actively managing the money. It is clear why brokers are tempted to push annunities even when they are not appropriate investments.

Investors were shaken by the slump in technology stocks and the broader market, during 1999 through 2002. They looked for something safer to invest in. They were prime targets for brokers selling variable annuities because they seemed safe.

Annuities were particularly tempting for people looking for a fixed income from early retirement. They mistakenly thought they would get a set amount per year for life, and some stockbrokers allowed their clients to believe this. Investors were in for a shock when the market dropped.

Many life insurance policies and annuities have been sold as investments which will go up in value if the stock market rises but are insured against losses if the stock market falls. This sounds too good to be true because it is not. What is not properly explained to investors is that someone must die for the guarantee to ever pay off. In reality, such life policies or annuities are nothing more than mutual funds with term insurance attached. If the stock market goes up, the mutual fund may rise somewhat, but the investor has paid substantial fees and the term insurance portion is worthless. If the stock market goes down, the mutual fund falls in value and the investor has lost money, plus has paid the substantial fees. The cost of term insurance, which may not even be applicable, is quite small.

Annuities are not risk-free investments, and are in some ways worse than stocks, because the investors are locked into the investments due to fees, structures, and tax consequences. Investors have to pay a surrender fee to withdraw their money, usually the amount of the commission. Although some do come with a guaranteed return upon death of the investor, there usually is no guarantee of value before death and in fact, the investments can be very aggressive and risky.

Investor tips from the SEC on variable annuities.