Top Five Mistakes To Avoid When Buying an Annuity

Buying an annuity or any other investment is a big decision and requires a great deal of thoughtful planning.

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Investing in annuities can be a hot-button issue for some people. Some financial advisors love them and others hate them. I am more of an investment agnostic. I prefer to take a balanced approach when investing for retirement. I am likely to recommend a combination of safe and smart-risk options.

This is especially important for those in or beyond the 11 critical years of retirement. Those years are the five years before, the year of retirement and the first five years after retirement. Investment decisions made during this retirement "red zone" are critical to maintaining your best lifestyle once you enter the distribution phase. I have compiled the five biggest mistakes that I have seen retirees make when purchasing annuities.

Buying a Variable Annuity

Variable annuities may look good on paper, but they are loaded with retirement headwinds. Though there are some initial guarantees made, your money is still at risk of market volatility, meaning your principal can be lost to market fluctuations. Further, the fees inside most variable annuities are very high. Variable annuity fees can be in excess of 4% annually. Fixed indexed annuities can provide similar performance over time but with no market risk and far lower fees if any.

Not Using an Independent Advisor

There are two types of advisors: captive and independent. Captive agents are generally employees of the insurance company and therefore are only allowed to offer products from that company. This limits their ability to place you in the plan that is the best for your situation.

Independent advisors, on the other hand, are able to represent different companies. This allows the advisor to shop the market for you based on your specific needs. Most independent agents (although technically agents of the carriers they represent) consider themselves to work for the client and not the insurance companies. This eliminates any conflict of interest created by a captive employment situation.

Using a Financial Advisor Who Is Not a Fiduciary

Under captive and independent, there are two subcategories that are of importance to the consumer: fiduciary and non-fiduciary. Fiduciary advisors are held to a legal standard of always making recommendations that are in the best interest of the client, without regard for what may be best for the advisor. Non-fiduciary agents and brokers are held to the lower "suitability" standard.

The suitability standard says that a broker may sell the consumer a product that is "good enough" but may pay the broker a higher commission. For example, a consumer tells their broker that they would like to invest in a small-cap mutual fund. There are many funds on the market that would fit this description. The non-fiduciary broker has narrowed them down to two that would be suitable for the client. One has lowered fees for the client but also pays a lower commission to the broker. Fund number two has high fees for the client but also pays the broker a higher commission.

Based on the suitability standard, the broker is allowed to place the client in the higher fee, higher commission fund, even though the lower fee fund will probably outperform. A fiduciary advisor would be duty-bound by law to recommend the lower-fee fund because it is in the client's best interest.

Paying Fees for Annuity Riders That You Will Not Use

Fees are the enemy of performance. As mentioned above, variable annuities can have very high fees. Fixed and indexed annuities are not immune from fees, though. Most fees inside fixed annuities are associated with the optional riders that can be added to the base annuity chassis. The most common riders added to fixed and indexed annuities are lifetime income riders and enhanced death benefit riders. Both of these riders are useful and the fees are justifiable if your objective in purchasing the annuity is lifetime income or gaining an enhanced death benefit.

If that is not your goal, then you are wasting your money. Let's say that you are only interested in a safe way to gain a reasonable rate of return for a set number of years, then you want the flexibility to move to a different investment vehicle. You already have plenty of income from other sources and enough life insurance to cover all of your final expenses and legacy plans. In this case, adding a lifetime income rider to your fixed annuity for a fee of 1% would be a waste of money.

Buying an Annuity From an Insurance Carrier That Does Not Specialize in Annuities

There are many insurance carriers that offer annuities. Some of these companies specialize in annuities and others, although they may be great companies, only offer annuities as an ancillary product. Their actuaries (the mathematicians who price the products) are more focused on the primary product lines of the company, such as whole life or Medicare supplements.

A carrier whose sole focus is annuities has actuaries who are experts in the annuity space. In fact, most annuities are designed by third-party actuarial firms. This allows the carriers to focus on the administration of the plans, and managing investments and customer service, rather than spending valuable resources on the constant development of new products.

Buying an annuity or any other investment is a big decision and requires a great deal of thoughtful planning. Most annuities have surrender charge schedules built into the contracts. These schedules can cause high fees to be applied if the annuity owner were to surrender (cancel) the contract before the pre-set time — usually ten years. This means that it can be very costly to change your mind.

So, if you are considering adding an annuity to your retirement portfolio, it is in your best interest to seek the advice of a reputable, local and independent financial advisor who follows the fiduciary standard. Make sure that they are able to explain your options to you and that you fully understand the annuity contract. Finally, don't be afraid to get a second opinion if you are the least bit unsure. It is, after all, your money and your future.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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