Biggest Annuity Investment Mistakes

Investments are like medicine. They are rarely good or bad per se. Instead, people may pick the wrong kind or the wrong amount for their particular circumstances.

In this respect, annuities are like other investments. They have beneficial features and drawbacks. They are well-suited to some people and circumstances and poorly-suited to others. Not surprisingly, annuity investment mistakes usually result from badly matching annuities to particular investors and circumstances, or from over- or under-allocating annuities inside particular portfolios.

There are at least two ways of gauging the size of an investment mistake. A “big” mistake might be one that is highly costly in monetary terms. A “big” mistake might also be one whose error is transparent – a head-slapping, face-blushing mistake that later seems incomprehensible. We must consider the question from each of these angles.

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Annuity Investment Mistakes by Young Investors

Annuities are long-term, retirement-oriented investment vehicles. We know they are long-term because they almost always contain surrender charges that penalize the purchaser for withdrawing money within ten years or so. In other words, you have to hold the annuity for a decade or more to dodge the surrender-charge bullet. We know they are retirement-oriented because IRS levies a 10% penalty on annuity withdrawals made prior to the holder’s age 59 ½. (That comes in addition to the ordinary income tax paid on the withdrawal.) Another reason we peg annuities as retirement vehicles is that their signature feature – annuitization, or withdrawal of level periodic amounts for life – is geared to taking income from the investment. Prior to retirement, our concern is with growth – getting wealth to grow as steeply as possible. In retirement, our focus shifts to income, which is what annuities are all about.

These inherent properties of annuities make them a very dubious choice for young people. If young people make an annuity investment mistake, it is apt to be a big mistake in both senses identified above. It is “big” because it is obvious – young people need aggressive growth and liquidity, whereas the annuity focus is on conservative growth, income and (relative) illiquidity. Young people are investing for a retirement that is decades away, while annuity investors are preparing for a retirement that will commence in a decade or so.

An annuity investment mistake made early in life is also “big” because it will likely prove expensive. Unfortunately, most people view a big investment mistake in terms of an explicit monetary loss – say, investment in a company that declares bankruptcy and whose stock price falls to zero. The same safeguards that make annuities a conservative investment make this sort of disaster wildly unlikely. In economic terms, however, an opportunity (implicit) cost is just as real and costly as an explicit cost. Investment in (say) a high-cost variable annuity might cause a young investor to incur annual costs that are 1-2% higher than would otherwise be incurred in a stock or mutual-fund investment. Over a working lifetime of 40 years, an initial $10,000 investment would grow to nearly $480,000 at a 10% rate of return, but only to $240,000 at an 8% rate of return. The size of the loss – $240,000 here – is a positive function of the investing time horizon. Mistakes made early grow in magnitude over time; the longer the time horizon, the bigger the loss.

There is a possible rationale for early investment in annuities. Young professionals or business owners may wish to use the immunity of life insurance products from liability judgments as a shield to protect their assets. Thus, they might prefer shielded equity investments in variable annuities to naked investments in stocks or mutual funds, provided their state law allows the shield.

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Annuity Investment Mistakes by Older Investors

Annuity investment mistakes made by older investors may be generically similar to those made in youth, but may differ in magnitude. The annuity feature most unfavorable to older investors is its illiquidity. Older investors may need money to cover medical emergencies or to finance lump-sum consumption purchases. Annuity assets may be either unavailable or costly to use for these purposes. For example, a surrender charge of (say) 8% may be incurred on an annuity withdrawal of $100,000. $8,000 is too stiff a price to pay for the privilege of using your own money. Still, it is unlikely to deal a fatal blow to a portfolio.

A different – but common – mistake made by older investors is to purchase variable annuities for a tax-advantaged account such as an IRA. This is an obvious error. The chief advantage of a variable annuity is its tax-deferred growth on equity investment, but the IRA already provides that. Rather than utilize the mutual-fund-equivalent subaccounts inside a variable annuity, the investor should probably opt for a straight mutual-fund investment, which typically has lower annual expenses than the variable annuity. Higher annual investment costs of (say) 2% on a $100,000 portfolio would reduce the investor’s wealth by $240,000 over a 20-year investing horizon. Variable annuities are good vehicles for tax-deferred investment when the investor has already made maximum annual contributions to tax-advantaged accounts such as IRAs and 401(k)s and still wants to invest more money.

All-Purpose Annuity Investment Mistakes

Some mistakes are universal in character, transcending categories like age or income. Failure to read the annuity contract carefully is the most common of these. The most likely result is either the loss of a desirable option or a misunderstanding of the contract’s mechanics. Death benefits to beneficiaries differ between companies and contracts, and failure to review the contractual choices available may result in lower or less-convenient benefits to heirs. Indexed annuities typically employ complicated formulas for calculating the index number and crediting benefits to the holder’s account. Failure to read or understand the formula can lead to inaccurate expectations and disappointment. Because of the insurance features of fixed annuities, this disappointment will not reflect an explicit loss – just a smaller gain than was anticipated.

Annuities have a reputation as high-cost investments. For example, variable annuities charge management expenses for their subaccounts and additional expenses for setting up and running the variable annuity itself. This second layer of fees can reduce the investor’s effective rate of return by 1-2% per year – a loss that is no less significant for not being “out of pocket.” All the costs are listed in the contract, but that doesn’t help the investor if the contract goes unread.

Surrender charges are frequently overlooked. This may cause an investor to unwittingly incur a substantial charge, since the charges often range between 5% and 10% for the first year. Carelessness may also work in reverse; the charges are high for the first year or two but usually decline to 1% for subsequent years. Failure to appreciate that fact may cause the investor to mistakenly forego a beneficial withdrawal.

The Biggest Annuity Investment Mistake May Be Not Buying One

The word “mistake” tends to conjure up pictures of bad investments. Sometimes the worst investment is the one you don’t make. In this vein, the failure of a conservative investor to purchase an annuity could easily end in disaster. The signature feature of annuities is the option to take guaranteed lifetime income. Today, lengthening life expectancies increase the value of this feature. Picture yourself, with your funds completely exhausted, at 85 or 90 years of age. Perhaps an aggressive, risk-loving investor might consider the potential for gain to justify this risk. For a conservative investor, however, this outcome is a true calamity. On the list of potential investment catastrophes, this must rank near the top.

Summary

To err may be human, but contracts are notoriously unforgiving. Early error can be the most costly, because the ramifications may be felt over decades to come. The impact of higher-than-necessary investment costs, for example, may be felt over several decades. This might make the difference between a comfortable retirement and a penurious one.

One problematic feature of annuities is their limited liquidity. This is seldom as serious as an explicit loss of money but it can lead to a lower quality of life. This can be a problem for young and old alike.

Failure to read the annuity contract carefully is a universal error. It may cause the investor to overestimate the annual return available or overlook desirable options provided by the contract.

It would be wrong to assume that the only kind of annuity investment mistake is one of commission. Failure to purchase an annuity can be a disastrous mistake for a conservative investor. To envision this, simply picture yourself with funds completely exhausted at 85 or 90 years of age.

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