Have you ever been excited about something only to realize it’s not what you think?
Time and time again, this kind of scenario happens in our lives. A recent trip I took with my wife is the perfect example of how a dream can fall short of reality.
I was traveling to New York City to work on a long-term project, but decided to switch things up. To transform this trip from work-only into something fun, I chose to bring my wife along.
Since this trip was booked by a client, I didn’t have a lot of choice in where we stayed. Still, I was pumped about the trip and optimistic about how it would pan out. My wife and I looked at the brochures for our hotel before we left, and were extremely excited by what we saw. Not only was our hotel in the middle of Times Square, but it looked fairly swanky and definitely on the higher end.
When we arrived though, our hopes for a blissful and upscale stay were quickly dashed. Outside of the fancy hotel lobby, the hotel wasn’t what it seemed. Our room was tiny and not nice at all; my wife and I couldn’t even fit in the bathroom at the same time. And although we were right in Times Square, our view overlooked a roof,a chain link fence, and some pigeons.
I distinctly remember my wife’s disappointed glance. “What is this?” she asked. “Where are we?”
It wasn’t the worst thing in the world. I mean, we’ve stayed in all kinds of lower end hotels and motels before.
The big difference is, we were sold an entirely different experience. We were sold luxury, opulence, and big time New York City living, when what we actually received was quite the opposite.
The Annuity Illustration Optical Illusion
You’re probably wondering what this has to do with investments, and you’re right to wonder. Remember how some things aren’t even close to how they seem?
Unfortunately, a lot of investing scenarios turn out similarly, especially when we talk about annuities. When you sit down with a financial advisor to talk about buying an annuity, you’re often sold a scenario that isn’t exactly what it seems.
I have experienced this situation far too many times when working with a new client. In each case, a client was being sold an annuity based on wild assumptions, only to end up on my doorstep shortly after.
It usually starts like this. A new client has been looking for principal protection and guaranteed income. Once they began talking with their old financial advisors, they were presented with the idea of an annuity and given an annuity illustration that highlighted what was probably the best case scenario. In case you’re unaware, an “annuity illustration” is a packet of information that shows what kind of return an annuity could potentially bring.
The key word here is “could.” With an annuity illustration, you’re basically looking at projections for the underlying investments in an annuity. Projections – not guarantees.
Understanding how annuities work is another important piece of this puzzle. Basically, an annuity is a contract between you and an insurance company that says they’ll provide you with a certain amount of steady income at some point in the future. Annuities come in three main varieties – fixed, indexed and variable. While a fixed annuity offers a fixed rate of return, indexed annuities offer a guaranteed minimum return and a fluctuating benefit based on the performance of underlying investments.
It’s the variable annuities that catch people off guard the most and create the “Annuity Illustration Option Illusion” we’re getting ready to talk about. With a variable annuity specifically, your entire return is based on the performance of the underlying investments in your subaccount. This means more risk, but it also means you have more potential for return.
This is where optical illusions come into play. When a financial advisor is trying to sell a variable annuity, they’ll create an illustration that shows potential return. Whenever you get these illustrations, they are at least twelve or fourteen pages long. I mean, there are so many disclosures and disclaimers along with so much fine print that nobody reads.
A lot of times, the mutual funds offered in the subaccount of variable annuities aren’t that great. There are always exceptions to that, but the ones we’ve stumbled upon during the past few years haven’t been stellar. And we haven’t even gotten into the costs of variable annuities. Most of the time, variable annuities cost anywhere from 2 – 3.5% and sometimes higher.
It’s these illustrations that are worrisome, mostly because we tend to focus on the numbers presented and not on reality. An annuity illustration might project you’ll earn 8 percent return on your money and a specific return for the rest of your life. A lot of times, this projection is based on everything under the sun going right, and nothing going wrong. In other words, they offer the best case scenario only.
Regrettably, most annuity illustrations don’t outline ongoing fees properly, either. So you might fixate on your supposed return without even knowing how much you’ll pay along the way.
Annuity clients may also not understand the word “potential.” With an annuity illustration, you’re shown your potential earnings based on a projection. In reality, your return may not end up being anywhere close to that – especially after you deduct the outrageous fees we talked about.
5 Common Annuity Mistakes
The “Annuity Illustration Optical Illusion” can be costly if you fall for it. So, how can you avoid becoming a victim? And what should you watch out for as you search for investments that provide both guaranteed income and principal protection?
I reached out to several other financial advisors to get their take on annuities. Based on their advice, these are some of the common mistakes people make when looking at annuities:
#1: Don’t believe illustrations based on impossible scenarios.
A lot of times, annuity illustrations use past performance to project future results. Since past performance isn’t a good indicator of what the future holds when it comes to investments, this is a mistake.
As an example, “don’t fall for an annuity illustration that uses historic bond performance,” says Jose V. Sanchez, financial contributor for LifeInsuranceToolkit.com.
“This is misleading as it is nearly mathematically impossible today. There is little hope that interest rates could decrease in the way the illustration suggests. We are no longer in the decreasing interest rate environment where these bond-based portfolio illustrations achieved their attractive returns.”
#2: Don’t buy something you don’t understand.
“Some of the biggest mistakes investors make when purchasing a Variable Annuity is not truly understanding the product,” says Joseph A Carbone, Founder and Wealth Advisor of Focus Planning Group in Bayport, New York.
“More often than not, when I speak with a client or prospect that purchased an annuity from another institution, they do not really understand the product and they are sold on the features of the contract.”
As an example, the guaranteed income riders referred to as GMIB or GMWB sound amazing. They will guarantee a specific growth on the benefit base each year and then guarantee an income stream for the reminder of their life.
“But most clients do not understand if they want to take out more than the income benefit schedule those guarantees go away,” says Carbone. “Or that they are paying almost 4% in fees per year to have this guarantee.”
#3: Beware of illustrations that predict outrageous returns, with few mentions of fees.
“Watch out for variable annuity illustrations that show above average market performance without clearly disclosed fees,” says Minnesota Financial Advisor Jamie Pomeroy.
Brokers who sell variable annuities with an “account value” and a separate “benefit base” are notorious for illustrating and emphasizing the success of the contract based on high average market performance, he notes.
“They illustrate your benefit base, or your future income amount, increasing dramatically based on market performance, not worst-case, or even an average-case scenario” he says. To find all of the fees involved, however, you’ll have to dig or ask specifically.
#4: Don’t forget to consider the length of your commitment.
While annuity fees are often hidden deep in the fine print, one fee in particular is an especially important consideration, says Russ Thornton, founder of Wealthcare for Women.
“One fee that is pretty clear if you look for it is that your money will likely be tied up in this annuity for 6-8 years (or more) unless you’re willing to pay hefty fees to get your money back out,” says Thornton. “The companies that manufacture these products do this so they can earn back the money they paid in commissions to the insurance agent that sold you this product to begin with.”
#5: Don’t forget to apply the “smell test.”
According to North Dakota Financial Advisor and host at Retirement Starts Today Radio Benjamin Brandt, many variable annuity brochures paint a picture that doesn’t even make logical sense.
“Let’s take a 5% guaranteed income payout for example; the contract will send you 5% of your accumulated benefit each year as retirement income. Seems simple enough, but once we add the 2-3% per year in hidden fees, things seem less clear. M&E expense, rider fees, sub-account expense ratios, administrative fees, all start to add up. Add the hidden fees to your guaranteed payout, your contract could start the year 8% in the red!”
This is where the ‘smell test’ is helpful. What is the likelihood that a 60% stock 40% bond portfolio (generally the mandatory investment mix) will consistently produce an 8% return? Possible, but not probable.
“Toss in an economic downturn and you will be left with level payments for life, not the ever-increasing income illustrated in the glossy sales brochure your agent showed you,” says Brandt.
Final Thoughts
None of this is to say that all annuities are bad. In the real world, there are plenty of scenarios where buying some type of annuity is the smartest move.
“If you have contributed the maximum amount to your tax-advantaged retirement accounts and still have money you would like to earmark for retirement, you might consider taking advantage of a low-cost deferred variable annuity,” says San Diego Financial Planner and founder of Define Financial Taylor Schulte. “It can serve as another tax-deferred savings vehicle for your long-term goals.”
Of course, there may be additional instances where an annuity is a smart buy as well. As with any other type of investment, an array of factors and individual client details come into play when it comes to figuring out the best way to invest.
Still, it’s crucial to investigate annuities before you buy. Most importantly, you should understand the array of fees you’re paying to secure a guaranteed income stream for life. Second, you should take a closer look at any illustrations you’re presented to see if they pass that ‘smell test’ we’ve talked about.
Also remember this often repeated rule of the universe when it comes to annuities and illustrations:
If something sounds too good to be true, it probably is.
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