About a month ago I wrote a column about how some financial product marketers use fear to sell their products. While I chose to focus that article on the dangers of signing up for a reverse mortgage, there are other financial products I would also advise people to avoid in most circumstances.
With the recent downturn in the stock market, many are feeling anxious and wondering if their life’s savings are at risk. Because of this, annuity vendors are out in full force attempting to convince you their products can take away the risk that investing in the stock market brings, while providing you a safe, guaranteed return on your investment for the rest of your life.
So what exactly are annuities, and can they really help to eliminate risk from your retirement plan? While there are a multitude of annuity types, generally, annuities are investment vehicles issued by insurance companies primarily to provide guaranteed income during retirement.
For many who are extremely risk averse to market fluctuations, immediate income annuities with their guaranteed lifelong payments can be very enticing. The problem with this kind of investment is they do not eliminate risk. They simply change its form.
Probably the most dangerous type of risk you must be aware before purchasing one of these products is inflation risk. We all know that things cost a lot more now than they used to. For most working people this extra cost of living gets offset by increases in take-home income. But, as a retiree, if you are invested in an immediate income annuity, the payment amount you receive does not go up as the value of the dollar goes down. Since for most seniors, medical expenses become drastically higher as they age this reduction in real income paired with increases in living expenses can be catastrophic.
Another major risk you take on is liquidity risk. Large sums of money invested in the market can be accessed if need be. While we always advise retirees to be cautious when requesting distributions from their retirement accounts, an advantage can come from having money available if an emergency occurs. However, once payouts begin on an immediate income annuity, in almost all cases, you have no ability to access the value of the lump sum you invested. Seniors needing extra cash are often forced to take on unplanned debt.
A third major risk you take on is risk of early death. If you have a large sum of money in an IRA, and you die early, the beneficiary of the account ultimately receives those funds. However, in many cases, these annuity payments end as soon as the individual or individuals covered pass away. That’s why savvy insurance salesmen often sell the client an additional life insurance policy to go with it. While doing this does add a layer of protection, it also adds an additional commission for the salesperson, and an additional cost to the buyer.
The final risk I will talk about is the insolvency risk of the insurance company itself. By that, I mean the risk that the insurance company responsible for making your monthly payments might run out of money. Unlike Social Security, and federal pensions that are backed by the government, these annuities do not offer the same guarantees. They are purely reliant on the insurance company that wrote the policy’s ability to pay. If they go out of business your payments stop.
Before making a decision on products like these. I would strongly encourage you to meet with a financial adviser who is held to the fiduciary standard. By law, firms like Stewardship Capital are required to provide advice that is in the best interest of the client. The majority of annuity salespeople are not bound by this high standard. That’s why they are often willing to provide dinner at some of the fanciest restaurants in the metro free of charge just for the opportunity to talk to you about the products they sell. Know the facts before signing up. If you don’t, the steak they buy you could cost you more than you ever dreamed.
Luke Davis is the director of operations and compliance at Stewardship Capital in Independence.