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Why are Annuities So Confusing?

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Last week a friend brought up the news story of NFL player Rashard Mendenhall retiring at the age of 26. While that may sound absurd to many people, he makes a good case in that article. The world of a National Football League player is non-stop. With social media, everyone is watching all the time, and spreading every smallest detail to potentially millions of people... instantly. Then there's the racism that he cites. Then there is the increased awareness of permanent injuries - both to the body and the brain. Any of those would probably be enough to get me out of the game, but combined... well, as I said he makes a good case for retiring.

However, this is a financial website and talk of retiring always comes down to money. He says that he's made a bunch of money. I'm hoping he's managed to keep it. It's no secret that American professional athletes have problems managing at that money. There's a reason why there's a a Wikipedia page detailing all the stories and sources. I'm not really that surprised, as people with little financial experience are given a lot of money at a young age. They occasionally get targeted by scammers billing themselves as experts, which can exacerbate the problem.

In any case, it got me thinking about a solution. I've long been a proponent that anyone coming into a lot of money (let's say 3 million or more for sake of argument) should get an annuity. An annuity "is any continuing payment with a fixed total annual amount." The idea is that you put a bunch of money in to guarantee you a stream of income for a set length of time (or the rest of your life). This solves multiple problems:

  1. It eliminates the possibility of spending it in deprecating assets (think fancy cars).
  2. It keeps that kid in the third-grade who lent you half a sandwich from knocking on your door to ask for a few hundred thousand dollars.
  3. It buys you a level of financial security. You can sleep well at night knowing that you've got money coming in for the rest of your life. In short, you buy financial freedom.

I think at least two types of people should get these. One is athletes like Mendenhall who are likely to earn their large salaries over a very short span of time. The other is lottery winners. Interestingly, 98% of lottery winners avoid the annuity option for a lump sum. The advisor in that article, Don McNay, makes a great point, "Don't take the $100 million, take the $5 million a year. If you run through that the first year, you have 19 more chances to figure it out." (Though in that case, you wouldn't get the option to take the $100 million, you'd surrender some 35-50% to take it as a lump sum.)

All this build-up finally gets me to the point of the article: Why are annuities so confusing? First there are so many different types, equity indexed, variable annuities, fixed annuities. If you are trying to find the costs, good luck. Here are a few of the articles on the hidden costs from reputable sources: CNN Money and Wall Street Journal.

That Wall Street Journal article particularly paints a horrific picture: "With the couple listening on speakerphone, Mr. Cutter got a rundown of all the fees the couple was paying: 1.4% for administrative expenses, 1.1% for a rider to lock in the 5% annual return, 1.2% for a mortality expense fee, wrap fees, and an adviser fee, which together totaled 5.8%... The couple was shocked that the cost of their annuity was higher than its annual return."

That's what I mean when I ask why annuities are so confusing. Imagine putting your money in bank that promised you 5%, but charged you 5.8% in fees. You wouldn't do it. However, with all these fees and no clear disclosure like an expense ratio for mutual funds and ETFs, it's hard to know what return you are getting for your investment. At least the former CNN Money article has a checklist of fees and what is typical, so you can compare them.

It it isn't like variable annuities make things clearer. As well-known expert Walter Upgrave says in this article: "My antennae automatically go up whenever someone tells me an adviser has recommended moving his money into variable annuities. So I'm glad to see you're not just blithely following this suggestion."

Over the 8 years that I've been blogging about personal finance, I think I've established myself as a big nerd. I've been reading personal finance magazines since I was 13, maybe even a little before. Yet, I have no interest in learning about annuities because it doesn't seem like there's any standardization as in the mutual fund industry. There aren't hidden fees that I have to obsessively comb through.

I want to give annuities a fair shake, because I think they can and should be a good retirement tool. I just have difficulty in doing it. Maybe the answer is in these low-cost direct sold options from companies that I (mostly) trust such as Fidelity, Vanguard, Schwab, T. Rowe Price, and TIAA-CREF.

Reader, let me know in the comments if I'm being overly harsh here. Have you looked in annuities? Did you find them easy to understand without hidden fees?

Posted on March 18, 2014.

This post deals with: ... and focuses on:

Investing, Retirement

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8 Responses to “Why are Annuities So Confusing?”

  1. myself says:

    hi lazyman, do you by chance have an analysis of the annuties that WFG offers esp ING and AVIVA? is their NET Rate of return competitive or higher than banks? are their fees reasonable?

    • Lazy Man says:

      I’m going to presume that WFG is Wells-Fargo? I don’t know know much about them, and haven’t done any analysis. I’m not really at the annuity stage in my life… and quite frankly they are so confusing that I’d probably just not use them in favor of something that I understand better.

  2. MJS says:

    As someone who sold several annuities over my 9+ years as a financial planner, I can tell you that there are great companies and advisors and shady companies and advisors (like most industries to be honest). I have several family members in annuities and not one is unhappy with how they are working for them.

    Just like any financial instrument, they can be either effective or abused. With the right client, income and fixed annuities definitely have their place. In a bull market, it is hard to justify a variable annuity (except one specific structure) without looking at some riders that work well. Equity-Index Annuities are lawsuits waiting to happen and several top financial services companies prohibit their agents from selling them.

    As an aside, Walter Upgrave is one of the worst writers in the industry. He is a shill for Vanguard and bashes pretty much every other company. He is all about the fees and not at all about rate of return.

    I think in general, you are spot on with your analysis, but in the example you gave of fees being higher than the return, that is not the norm. I sold several companies annuities and I sold AAA rated companies and never ran in to what you described.

    If you ever wanted a guest writer on the types of annuities and who should be buying them (from an outsider that was once an insider), I’d be happy to offer my services.

    • Lazy Man says:

      I definitely believe that there are great and shady companies and advisors. That’s why I always look for transparency. Take Vanguard that you mentioned. Is it likely that Vanguard’s S&P 500 index fund is at all shady? If anyone thinks it is, I’ve got a bridge to sell them.

      In defense of Walter Upgrave, when you read that monkeys throwing darts (wait it’s monkeys OR people throwing darts – the AND case doesn’t seem smart) picking stocks are as good as the pros, it is hard to argue for rate of return over lower fees. And this is coming from someone (me) who rode Bill Miller’s Legg Mason’s success for a decade and still picks individual stocks (though with a very small part of his portfolio).

      I would definitely love a guest article on types of annuities and who should be buying them. That would be great.

      I knew the example of fees being higher than return was definitely an outlier… probably 1 in 1000 or even less. However, it was an illustrative example of what was possible because of the lack of transparency.

  3. […] I wrote about how annuities can be confusing, especially with hidden fees. I was wondering if it was possible for me to create something that […]

  4. MJS says:

    I’ll put something together for you over the next week or so and then feel free to edit and run as you see fit. We can even discuss offline first if you want after I complete a first draft.

  5. Raginn says:

    There are many options and for some people, annuities are the way to go. They do tend to need a large influx to start, but then they are settled and regular. Since there are three main types, you will want to investigate all three closely before picking which one might work best for you.

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