GF¢ 069: Understand Your “Why” Before You Buy an Annuity

Want to know what gets me really fired up?
If there’s one thing that really grinds my gears, it’s when we find out a new client unknowingly has an annuity in his or her portfolio.

Now, it’s not just the fact they have an annuity that’s the problem.  As I have shared on several occasions, there are definitely times when owning an annuity makes sense. The big exception here is that the annuities I tend to discover are variable annuities.

Here’s what makes me angry: When I ask my new clients why they purchased a variable annuity to begin with, few of them can answer.

The vast majority of the time, they quietly shake their heads as if they have no idea why they have a variable annuity, or how it works.

What this really means is that their former financial advisor sold them a variable annuity without explaining why. Or they cleverly bundled it in with other investments without justifying it or taking the time to explain why it would benefit their client.

I wish I could say that this is an isolated incident and it very rarely happens, but I can’t. The truth is, it happens so often that I am no longer surprised. And 99 percent of the time, we find that our client wasn’t a good candidate for a variable annuity to begin with.

Here’s the truth some financial advisors don’t want you to know:

By and large, variable annuities are bought and sold because they help financial advisors score huge commissions.

Who cares if your annuity pays off when they score a huge commission check on the front end? Sadly, in this situation, you’re left holding the bag (or the annuity).

Three Questions to Answer Before You Buy an Annuity

As I mentioned earlier, annuities can have their place. Still, you should take time to understand these complex investments before you invest your dollars into one.

In my eyes, there are three pieces of criteria everyone should meet before they invest in an annuity. To find out if your situation fits the bill, you should be able to answer these three questions first.

1. Do you need principle protection?
2. Do you need a guaranteed income stream for the rest of your life?
3. Are you interested in passing more on to your heirs than you currently have?

Before you move any closer to buying an annuity, let’s dive into each of these scenarios with a little more detail:

Question #1: Do You Need a Principal Protection?

If you want principal protection, an annuity is one of the few financial products that can help. Depending on your goals and needs, you could make this happen with a Fixed Annuity or a Fixed Index Annuity. I will caution, however, that you can get the same type of principal protection by purchasing a Certificate of Deposit, or CD, through your bank – and with very little hassle and almost no up-front costs.

Plus, there are additional risks to consider when purchasing an annuity for principal protection only. When it comes to annuities, the principal you’re trying to protect is only as safe as the credit rating of the insurance company that offers the annuity. In that respect, it’s crucial to consider the rating of any insurance company you plan to use. Before you purchase an annuity, make sure you double-check the rating of the insurance company before you dive in.

Question #2: Do You Need a Guaranteed Income Stream for the Rest of Your Life?

While some retirees have the benefit of a pension plan, many of today’s workers will not have a defined benefit plan to fall back on. In that respect, having an annuity can prove extremely helpful. With an annuity, you can create a predictable and guaranteed income stream that will be there when you’re ready to retire.

By purchasing an immediate annuity, you are able to select the times and stations where you generate an income – or structure your payments so you receive them for the rest of your life.

Another option that usually offers a higher payout, especially over a lifetime, is a Fixed Index Annuity. With this option, you’ll receive lifetime income benefits after paying for the additional costs of a rider. While this isn’t the best option for everyone, it might make sense for your situation if securing a lifetime income stream is extremely important to you and you aren’t worried about additional, upfront costs.

When you evaluate lifetime benefits, make sure the advisor you’re working with is able to choose among several different annuity options. Since rates are constantly changing, you’ll want to evaluate and compare several annuity quote options to make sure you are truly getting the best deal. While it’s smart to lean on your advisor for help, you should also verify he or she isn’t pushing you towards an annuity that will pay them a higher commission. That’s one thing I’ve seen happen far too often, and it’s something I caution my clients against all the time.

Question #3: Are You Interested in Passing More on to Your Heirs Than You Currently Have?

While annuities come in all shapes, structures, and sizes, many offer additional benefits or “riders” you can purchase. One of these additional benefits is a death benefit rider. With this option, the amount you invest into the annuity usually has a growth rate attached to it. Once you pass away, this guaranteed growth rate can be passed on to your heirs.

While it’s almost always a better deal to buy life insurance coverage for this purpose, one big benefit here is that death benefit riders don’t require a medical exam. If you have health problems or are older in age, you can add this option to an annuity to create a benefit similar to life insurance.

In one case I studied, a client had a $325,000 IRA they didn’t plan to use and were able to finagle that into a $786,000 death benefit they could pass on to their heirs. While that’s a pretty uncommon scenario, it represents another scenario where buying an annuity made sense.

The Bottom Line – Discover Your Motivation Prior to Purchasing an Annuity

Annuities have their place, but it’s maddening when my clients have them without knowing why. Most of the time, this is the direct result of a greedy financial advisor pushing products that earn the highest commissions possible.

If you want an annuity in your portfolio, the most important question to answer is, “Why?” Why do you want an annuity, and why do you need one? And would another financial product help you accomplish the same goals without the upfront and ongoing costs?

If you can’t answer those questions in-depth and with a full understanding of the benefits and drawbacks of most annuity products, you’ll be much better off investing your dollars elsewhere instead.