Everything You Ever Wanted To Know About Annuities But Were Afraid To Ask

If your well-rounded financial portfolio is a meal, then annuities should be part of the main course. Annuities are technically insurance products, but many people view them as investments—because, for all intents and purposes, they are treated similarly. There are many different types of annuities, but the main type is what people refer to as Lifetime Income Annuities, which work like a “Personalized Pension Plan.” These provide an income that you can’t outlive, sometimes starting immediately, sometimes deferred; when you put money in an annuity, you might put in a lump sum, or pay into it monthly or yearly—and then, at some point in the future (say, retirement), the company into which you made these payments begins paying you in regular disbursements.

Even for individuals who clearly see the value in annuities as part of their portfolio, it can be a challenge knowing where to begin. Annuities are misunderstood, sometimes misused products; investors are confused about how they work, what kind they should get, how much to “invest,” how long until payout and what returns to expect. I’ve spent the past six years making annuities my business and helping over 3,000 other financial services professionals to understand the ins and outs of these products. (I even run the largest annuity-focused social media group.) Here are the points I find myself educating people in and out of the financial industry about, again and again:

Betting Against The House

For people who can save now for more access down the road, annuities can be an excellent vehicle for retirement savings: You can set up a situation where, say, you put in $100,000 over time, and then at retirement, receive 8% a year (at current rates) for the rest of your life. (This is double what the traditional 4% rule allows for withdrawals from a portfolio.) Many people like this idea because they don’t have to worry about outliving their money; as ghoulish as it sounds, living too long is a significant problem retirees are facing today. With fluctuations in markets, people can outlive their money very easily without proper planning. By promising a guaranteed income, annuities hedge against the risk of living so long that you deplete your savings.

Annuities do have downsides such as reduced liquidity of that asset, so this solution isn’t for everyone, particularly if you know you’ll need that money sooner than age 59.5 or some other distant point. However, for those who understand longevity risk and need that stable paycheck, there is simply no other type of vehicle that is able to do what an annuity does—providing a guaranteed income for the rest of your life, however long that is.

Not All Annuities Are Created Equal

On a macro level, economists and financial analysts spend all day thinking about what kind of investments yield the best return; there is no global “right answer” for everyone. Moreover, given people’s financial planning and level of risk tolerance are variable, different choices will make sense to different investors. However, there are some criteria that I tell clients to look for when evaluating annuities, which can make all the difference in the success of the product over the long term:

1. Look closely at the company. I recommend sticking with companies that have an A- or higher rating from AM Best, or over 80 on the Comdex rating system, which compiles an average rating from other rating agencies. You should also look for companies that have been in business for more than a short period of time. We like to see companies that are 40, 50, 60, even 100 years old—companies that have been in business, and solvent, for a long time. Although Fixed Indexed Annuities date from only 1996, we want to see that companies have a strong history and a solid rating.
2. Find out the company’s TSR. Unfortunately, company ratings are only one piece of the puzzle. There are well-rated companies that have horrible products. So the next thing you need to look for—and it’s helpful to have an advisor go over this with you—is a TSR ratio. TSR, which stands for transparency, surplus, and risk, is a review of the company’s investments to determine which are high risk and which are low risk. When you have too many high-risk investments in annuity companies it’s a warning sign to be careful, because if the market goes sideways quickly, you then have to worry about insolvency. You don’t want a company going under when you’re relying on them for a lifetime income. I tell clients that the lower the TSR ratio, the better—ideally under 1000%.
3. Scrutinize the product. Of course, you can have a great company with a great TSR ratio and they can still make a terrible product, which in this context means the payouts are low, the design and features are just not competitive compared to other companies, nor is their ability to serve clients’ needs. Financial products like these have one goal: to make that company a higher profit margin. Alas, some of the biggest insurance companies out there have great solvency and great ratings, but their products are comparatively poor. The reason they have those big ratings is that they have a big profit margin—so these companies are safe from insolvency. But it’s helpful to remember that their big profit margins come in part from the consumers’ pockets. So, it’s important to balance that understanding with the value of a “big name,” and look carefully at the payouts and features of your investment.
4. Know the guarantees. A lot of annuities are sold on hypotheticals (and wishful thinking), but it’s not prudent to operate that way. That’s why in an annuity purchase my first question is always, “What is the guarantee on that account?” There are a lot of products that look really great on paper, and seem to show outrageous returns—but then, when you compare these optimistic projections to the guarantee, they’re not even in the same ballpark. So it’s very important, when you’re looking at a product with the intent of purchasing it, to be crystal clear on what the guarantee on this product is—not the hypothetical, not the “might do,” but what it “will do” first. You need this information in order to have a solid base for moving forward.

Combating Misinformation With Good Counsel

Annuities are great options that should be a cornerstone of any well-rounded portfolio. That said, it’s important not to get sold on unrealistic valuations and projections. A lot of these annuities are positioned as “accumulation annuities.” They are allowed to give you an illustration that’s hypothetical, which can be misleading to investors.

It’s also very important for consumers to find a trusted advisor when diving into annuities. Doing your own research is a great start, but a dilettante will never get to the point where they’ll have the same level of information available to them as someone for whom this is a full-time job. Just as you wouldn’t trust me (a full-time annuity expert) to take a scalpel in my hand and go perform surgery, it’s far safer to be advised on annuities by someone appropriate, so that you don’t risk messing up your retirement plan. There are a lot of resources out there, but also a lot of misinformation. It’s wise to seek the counsel of someone who can help you tell the difference.

Read more @Forbes