An annuity is an insurance contract between an insurance company and a customer. The customer pays the insurance company a specific amount of principal and in return has the option of receiving regular payments for life or a specific period of time or the customer can choose to let the contract grow on a tax deferred basis until the money is withdrawn. Annuity contracts have two distinct phases, the accumulation period and the payout period.
The payout period begins when the investor decides to "annuitize" the annuity by converting the assets that have accumulated into a monthly income stream which represents a return of principal and interest.
Insurance companies offer two general types of annuities, fixed and variable. Fixed annuities provide a specific rate of return while the return on a variable annuities depends on the investment returns of individual mutual fund sub-accounts subject to market risk.
Before investing in an annuity, a broker should determine whether or not the investment is suitable given the customer age, investments needs, station in life and risk tolerance.
- Did you need access to cash?
- Did you have income needs?
- Were you risk adverse?
- Did your heirs need a death benefit?
- Did you already have adequate life insurance coverage prior to purchasing the annuity?
If you have answered yes to any of these questions, you may have been the subject of a fraudulent annuity sale.
Over the last several years the notoriety of annuities have grown and are often the subject of sales practice complaints. The reason for this is simple — annuities are often sold to customers because the selling commission is among the highest of all financial products available for sale to retail customers and because the commission is paid by the insurance company directly to the broker. In other words, the customer is often told that the commission will not be paid from their pocket.
You might ask how this works? In order to insure that the insurance company will be compensated for the large commission it pays to the broker, the insurance company charges annual Mortality and Expense charges. The annual Mortality and Expense charge is usually one percent or greater. If a customer decides to sell or surrender the annuity, a Contingent Deferred Sales Charge (CDSC) is imposed. The CDSC is a penalty for early cancellation of the contract and typically declines from 7 percent to 0 percent over the first 7 years the annuity contract is in place.
The high commissions on variable annuities are just the starting point. Annuities also provide a steady stream of commissions and sales charges to both the broker and the insurance company. Broker's are paid trailing commissions. Annuities are also loaded with administrative fees and mutual fund sub-account management fees. By comparison, it is usually much less expense to own the same mutual funds in a brokerage firm account rather than through a variable annuity.
Often annuity companies will entice customers will buzz words like "guaranteed" income or a "guaranteed"; death benefit. These promises are often not what they initially seem to be. Annuity products that offer such guarantees also include additional fees in excess of the high Mortality and Expense charges, administrative charges and management fees. Customer are often sold a death benefit that they do not need.
Annuity swaps or exchanges are also problematic. Customers are often convinced to switch policies for benefits that are illusory or insignificant. An annuity swap generates new commissions for the broker and can start the clock back at zero on the Contingent Deferred Sales Charge that penalizes a customer for surrendering an annuity that is less than 7 years old.