Mel Lindauer, 07.16.10, 12:15 PM EDT
Watch out for teaser rates, surrender fees and an insurer's credit rating.
Imagine a CD-like product with lots of fine print "gotchas" and you've got a good idea of what a fixed deferred annuity is.
When presenting this product to prospective buyers, the insurance sales person will usually talk up all the good features, including a "teaser" interest rate that's higher than those being offered on bank CDs and sometimes even a "bonus" for buying the product. What they fail to mention, or mention in an oblique way (such as "this is a nine-year product"), is that the higher-than-normal interest rate might only be guaranteed for a short period (perhaps one or two years).
After that guaranteed period, the interest rate may revert to a below-market yield, but you're locked into that low yield by a high surrender fee that may last for up to 15 years. And, if you take your money out and you're not yet 59.5 years of age, you'll pay a 10% early withdrawal fee in addition to the surrender fee. Because of the surrender fee and the 10% IRS penalty for early withdrawal, unsuspecting investors often find themselves "trapped" in this low-yielding fixed annuity when much better investment options are available.
While fixed annuities might be sold as "similar to CDs," they are not guaranteed by the Federal Deposit Insurance Corp. And since fixed annuity assets are co-mingled with the insurance company's operating assets, they are subject to seizure by creditors should the insurance company suffer a financial setback. Fixed annuity products aren't considered to be securities, so there is no prospectus. The only information available to the consumer is the insurance company's marketing material and the insurance agent's sales pitch.
(An Equity-Indexed Annuity (EIA) is another type of annuity that is currently classified by the insurance industry as a fixed annuity, but the Securities & Exchange Commission disagrees and is taking action to have them declared securities. We'll cover EIAs in a later column.)
The ability for a fixed annuity to pay the guaranteed amount is based solely on the financial well-being of the insurance company you invest with. Because of this, the SEC suggests investors should purchase deferred fixed annuities from insurers receiving the highest credit worthiness ratings from these five insurance rating firms.
The SEC also explains that should an insurer default, the State Guarantee Fund will step in and "attempt to find a replacement insurer for your contract, or will offer insurance on a given amount of annuity investment (usually up to $100,000, but greater in some states.)"
You'll want to check out your state's guarantee and understand exactly what would happen if your insurance company failed before you ever consider purchasing a fixed annuity. Here are some valuable links:
--State Guarantee Funds
--Guarantee Association
--NOLHGA: What Happens When An Insurance Company Fails
--State-by-state listingYou can use this website to compare details on various fixed annuity products, including teaser rates, bonuses and minimum guarantees. You'll see that the guaranteed "teaser rate" period might only be one or two years and yet the surrender fees can run a long a 15-years. Those surrender fees are shown above each group of listings, but they're (intentionally?) hard to see. And finally, pay special attention to the last column in the chart which shows the "Guaranteed Yield to Surrender." You'll note that in many cases, it's barely above 1%, or between 1% and 2%. Even the highest ones listed are in the 3% range, a rate that one could currently earn on lots of much less complicated investments, including FDIC-insured CDs and Treasury-issued I Bonds.
Because of the low guaranteed total yield to maturity and the long surrender periods, we'll put most of these deferred fixed annuities in the "just say no" category.
Mel Lindauer, CFS, WMS is one of the founders of the Bogleheads community and co-author of The Bogleheads' Guide to Investing along with Taylor Larimore and Michael LeBoeuf. He is also co-author of The Bogleheads' Guide to Retirement Planning along with Taylor Larimore, Richard Ferri and Laura Dogu.