Opinion

Felix Salmon

Don’t buy index annuities

Felix Salmon
Jan 18, 2011 18:39 UTC

Lisa Gibbs has a great article on index annuities in Money magazine (HT: TFF). The short version: don’t buy them, and don’t let your parents buy them.

There are at least three scandalous aspects to the index annuity racket. First up is the commissions, of as much as 9%. Incentives matter, of course, and when financial products carry these enormous commissions, the people selling them will never have their clients’ best interest at heart.

That problem is exacerbated by the fact that not only don’t the salespeople have any fiduciary duty to their clients, they don’t even have to have securities licenses. Index annuities are technically an insurance product, which means that you can sell them with nothing but an insurance license — even if FINRA has torn up your securities license. That’s no mere theoretical problem: more than a third of all brokers of insurance annuities in Florida and Massachusetts have had their securities licenses revoked.

Gibbs explains how this egregious loophole survived Dodd-Frank. It’s exactly what you thought:

When details of last year’s massive financial reform bill were being hammered out, Democratic Sen. Tom Harkin slipped in an amendment affirming that index annuities are not securities — and therefore are out of the SEC’s reach. Harkin is from Iowa, home of five big index annuity sellers.

Gibbs singles out one company, Pinnacle Investment Advisers, which persuaded elderly investors to surrender old annuities, paying $208,000 in surrender fees in the process, and for its troubles earned both $126,000 in commissions and a lawsuit from Illinois’s securities division. But it turns out that the only reason that the securities division has standing to bring the suit is because Pinnacle was a registered investment adviser. If it was just an insurance broker, it would be out of their reach.

And on top of all that, index annuities are very bad at their main job, which is being annuities. To back up a bit: in old-fashioned defined-benefit pension plans, there was always a significant insurance component. The pensioners who needed the most money — the ones who lived the longest — would receive the most money. Meanwhile, those who didn’t need as much — people who died relatively young — would effectively subsidize the longer-lived. That’s a great idea: living people need money much more than dead people do.

Nowadays, however, with the move to defined-contribution pensions, all that has gone out the window. You have a certain amount of money, and it needs to last you the rest of your life, but you have no idea how long that life will actually be.

Annuities are the obvious way of solving this problem. You hand over a lump sum, and an insurance company promises to pay you an income so long as you’re alive. If you die early, you lose out (but don’t need the money any more); if you live long, you win, and do need the money.

The problem is that many annuities, and pretty much all index annuities, are sold as investment products:

Insurers say that index annuities are meant to be held over the long term. However, in the wake of complaints like Passanisi’s, they have added provisions to most new index annuities that allow you to take out up to 100% of your money penalty-free if you are diagnosed with a terminal illness or enter a nursing home.

This, of course, does a great job of undercutting the main reason why annuities ever make sense. The reason for me to buy an annuity is that I want to be subsidized by the short-lived if I turn out to be one of the long-lived. What I don’t want is for the short-lived to be able to get their money back in full, because then my subsidy goes away, and there’s no point in buying an annuity at all.

At the end of her piece, Gibbs manages to replicate an index annuity at much lower cost and with much more upside. Put 85% of your money into FDIC-insured bank CDs, and 15% into a low-cost S&P 500 index fund. Then, when you retire and are ready to start getting that lifelong income, buy a plain-vanilla immediate annuity designed to cover all or most of your basic living expenses; the rest should be kept invested according to your risk appetite.

What Gibbs doesn’t do is raise any hope that the Consumer Financial Protection Bureau or anybody else will start regulating and cracking down on the index annuity racket. Insurance regulators are reasonably good at regulating the sale of genuine insurance products. But index annuities are not insurance products, they’re financial investments. And they should be regulated as such, by a federal regulator.

COMMENT

I read this article which is linked in when you click on LISA GIBBS hyperlink name at the beginning of the article. Funny how she has comments disabled so that no one can call her out for being a registered securities advisor who has a vested interest in keeping your money under management. Of course she will have nothing but negative things to say about Index Annuities. Lisa and Felix… millions of Americans are tired of being told to keep their money invested in the stock market, only to lose it during a financial collapse like we saw in 2001 and 2007. Lives have been devastated and security advisors like Lisa have been hiding products like the Index Annuity which is the ONLY product that allows the investor to still earn money based on the performance of the stock market, while at the same time guaranteeing they will not lose a penny due to the negative performance of the stock market. People are tired of being told that the market will bounce back, or spend less money… we are not sure when your money will come back, but everyone lost money during 01′ and 07′. There is nothing wrong with diversifying someones portfolio using Index Annuity and stock market investment products together, but you sound ignorant saying that everyone should stay away from Index Annuities. Why aren’t they regulated by FNRA? Hmmm, could it be because it guarantees that they WON’T LOSE A PENNY TO MARKET PERFORMANCE? All you make an investor do with market investments is sign a piece of paper saying that they could possibly lose all of their money. Whelp, I guess you are covered then. When my mother lost half of her life savings in 2007 her advisor told her… “well you knew the risk, you just need to spend less money for now until you earn it back, and you are going to have to post pone your retirement.” Give me a break. Crooks. She should have moved her money to an Index Annuity a decade ago.

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A retirement-fund paradox

Felix Salmon
Jan 19, 2010 05:06 UTC

David Merkel is insightful when it comes to a huge status-quo bias in retirement funds. If we have a lump sum, we’re loathe to convert it to a guaranteed income, even when we value the guaranteed income that we do have extremely highly:

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors. Yet, they do not get bought by retirees. Why? Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money. They would rather sell a less suitable product that offers them another sale down the road. And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run. Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.

I suspect that one of the problems here is that it’s almost impossible to tell whether or not you’re getting ripped off when you’re buying an annuity. Unless and until a vibrant and competitive market emerges in such things, you might end up buying a million-dollar lemon with substantially all of your life savings, and no one wants to do that.

I’m not sure how much the issue of having a rainy-day fund for unexpected medical costs comes into play here: at the margin it might actually be better to be on a fixed income than to have a large lump sum which could easily get eaten away by medical bills.

I do think however that people massively overestimate the returns they can get on their money, and they often dream of leaving their heirs more money than they retired with. Such dreams almost never come true, but they also never die. The question is, how much are they worth.

COMMENT

Still TIPS have a defined life (30 years) which may not address those with good genes who are afraid of outliving their money, even given your valid inflation concerns. A properly constructed single premium, immediate annuity from an insurance company that one can have confidence in, with a reasonable premium, would be a valuable product for a whole class of people who are not comfortable managing their own portfolios and want the relative security of a monthly check. There is a reasonably large market here for Berkshire to get into if you’re reading Warren.

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