Insurance companies and other financial institutions love to sell annuities to deal with one of the biggest fears in many people who are nearing or already in retirement — the fear that they’re going to outlive their money.
But are annuities a good fit for you in your life?
What you need to know about annuities
Annuities are often advertised as safe investments that offer guaranteed income for life. But despite the hype, money expert Clark Howard hasn’t softened his stance against them over the years.
“They’re one of the hottest products in the investment and insurance landscape, but they’re poison for your pocketbook,” Clark says. “Of all the things you could for your wallet, buying an index annuity at any age is just about the worst thought possible.”
In this article, we’ll take a closer look at annuities and why Clark is opposed to all but two particular types of this insurance product.
Understanding annuities: Table of contents
- The danger of variable annuities
- The truth about index annuities
- 2 kinds of annuities that Clark does recommend
The danger of annuities
What are annuities?
First, you should know that annuities are various kinds of financial products that generate a fixed lifetime stream of income for the buyer to ensure that you won’t outlive your money.
When you purchase one, what you’re doing is taking a lump sum of money and handing it over to an insurance company. They are then contractually obligated to provide you with income for the rest of your life.
There are a few basic flavors of this product:
- Variable annuities – buy individual stock and bond funds
- Indexed annuities – are tied to stock market indexes
- Immediate annuities – take a lump sum and converts it into immediate monthly income
How do annuities work?
Both the variable and indexed types of annuities here are “deferred” products. That means they are long-term investments — often bought years in advance — that grow tax-free over time. You only pay taxes when you start withdrawing the money in retirement, similar to how a 401(k) or IRA works.
On the other hand, immediate annuities — which we’ll discuss later in this article — typically start paying out within the next 12 months. With this particular product, there’s a much shorter time horizon until you start getting money out of the policy.
The amount of monthly income you get from a standard variable annuity is impacted by a variety of factors. According to one recent estimate from CNNMoney, a 65-year-old man could get $525 a month in lifetime income from buying a $100,000 annuity. Meanwhile, a woman of the same age could get $490.
And just in case you’re wondering, this isn’t a case of women earning less than men. The woman’s hypothetical payout is lower because the actuarial tables say she’s likely to live longer than the man, so the lower payout accounts for additional years of payments.
Why Clark doesn’t like variable annuities
To understand why Clark doesn’t like variable annuities, you should understand that they are basically mutual funds wrapped in an insurance policy. They also come with a variety of insurance charges and other fees:
- Insurance charges (aka mortality and expense fee)
- Fees for the underlying investments
- Riders and options
- Surrender charges
By the time it’s all said and done, you could be paying up to 25 times the expenses you would if you were invested in the no-load index funds that Clark recommends in his investing guide.
Even worse, if you try to get out of an annuity, you have to pay massive fines. If you buy into a variable annuity and need to get your money before 15 years passes, the so-called “surrender charge” could be tens of thousands of dollars or more.
Finally, variable annuities are often pushed by salespeople on elderly folks during free meal seminars. The commissions the salespeople receive on a sale is huge. That why it’s often said annuities are sold, not bought.
“Remember, that is the most expensive ‘free’ meal you will ever eat,” Clark warns about those seminars.
The truth about index annuities
What is an index annuity?
Index annuities really took off after the stock market got decimated in the last decade. At that time, marketers saw the opportunity to take advantage of people who were worried about outliving their money.
Index annuities are sold with the promise that you can earn a return based on the stock market in good years, but that you won’t lose any money during bad years.
Why Clark doesn’t like index annuities
That promise is obviously very attractive to someone who is 65 and worried about having enough money for the rest of their life.
But the promise isn’t worth the paper it’s written on, Clark says.
In most of the convoluted contracts for this particular product, the insurance company can decide to change how much these policies earn each year. So, they can offer you a great deal upfront and pull a sucker move on you by changing the payout later. Then you’re stuck, unless you want to pay that huge surrender charge.
And what about the promise of getting the benefit of a rise in the stock market without the risk? What really happens is that they’ll give you tiny portion of gain of an index they select. They cap the amount you can get, and they don’t give you any credit for dividends.
“If you are past 60, index annuities are a danger to your financial health, your financial security and your long-term ability to live independently,” Clark says. “Kick the insurance person who tries to sell you that junk straight to the curb!”
2 kinds of annuities that Clark does recommend
If you’ve read this far, it may surprise you to know there are a couple kinds of annuities that Clark actually likes!
Immediate (aka life) annuities are a simple insurance product that takes a lump sum and converts it into monthly income, typically within the next 12 months.
Unlike variable annuities, this particular flavor of annuity has so little in the way of commissions that it’s rarely pushed by salespeople.
One common concern people have about immediate annuities is: What happens if you pour all your money into an immediate payout annuity and then you die next week? It’s true that all the money will be gone and there will be none for your heirs.
That’s why Clark says you can opt for a special provision called “period certain,” which means that there will be a guaranteed payout (typically for 20 years) even in the event of your death. Your monthly benefit will drop by about 10% if you take the period certain option, but at least it provides something guaranteed to your heirs if you were to pass away.
“As with anything else, there are good providers and bad providers of life annuities out there,” Clark says. “You always want an insurer with an A.M. Best rating of A+ or A++.”
Longevity annuities (aka longevity insurance) are a simple insurance product you buy that doesn’t start paying a living benefit until you hit 85.
“The idea is that with a longevity policy in place, you could plan to blow through all the cash in your retirement plan through age 84,” Clark says. “Because the minute you turn 85, you get a check every month for as long as you live.”
Insurers know from actuarial tables that most people who buy the policy won’t live to receive any money. But if you do live to age 85, you get that nice monthly check.
You won’t hear a lot of insurance agents talk about longevity policies because the commissions on them are so small. But they can be a great idea for so many situations where people might otherwise outlive their money.
If you want to explore the idea of buying a policy, ask an insurance agent for “the insurance policy that doesn’t pay any money until age 85.” Different people call it different things, but they’ll know what you mean based on that description.
Money expert Clark Howard so dislikes most annuities that he says they’re a four-letter word in his vocabulary! The only kinds of annuities you should ever look at buying are immediate and longevity ones, according to him.
If you have more questions about annuities, contact Clark’s Consumer Action Center — a FREE help line open Monday-Thursday from 10a.m.-7p.m and Friday from 10a.m.-4p.m. ET with volunteers available to answer YOUR concerns! Call Team Clark @ 404-892-8227.