In today's era of low interest rates, income-hungry investors look for any edge they can get. With traditional income-producing investments such as bonds and bank CDs paying very little in interest, many investors have turned to annuities in hopes of squeezing out some additional income. Yet as compelling as high annuity rates might look, these often-misunderstood insurance products can actually contain traps for the unwary that will dramatically reduce the effective annuity rate that is paid. Let's look more closely at annuity rates and some of the common ways investors get misled about their primary features.
Don't let teaser annuity rates lock you in
Fixed annuity contracts often include a provision that pays a premium interest rate during a certain introductory period. This rate, often known as a teaser rate, is typically well above what you could get from a bank CD or other income investment, and many people are tempted to buy annuities because of the prospect of getting those higher interest rates on their money.
The problem, though, is that those introductory rates typically only last for a brief period and give way to much lower annuity rates for the rest of the term of the contract. For instance, if you sign a 10-year contract for an annuity paying a rate of 5% in the first year and 1% in the remaining nine years, your average annual return will be about 1.4%. In many cases, the long-term payout on annuities will be lower than what you'd get from other investments, even if that short-term teaser rate looks high.
One common reaction to the teaser-rate problem is to conclude that you'll just close out the annuity after the introductory period ends. Yet annuities come with sizable surrender charges that can actually cost you money if you try to get out of your annuity contract early.
For instance, some annuities have surrender provisions that charge a 7% fee if you close out your contract in the first year after purchase. After a year, the fee drops to 6%, and then falls another percentage point annually until it eventually disappears. Other annuities have different time periods and rate-reduction provisions, but the general idea is the same -- if you want quick access to your money, you'll have to pay.
To give annuity investors a chance to access a portion of their money, some annuities allow you to withdraw as much as 10% of your principal each year without any surrender charge. Even here, though, it's worth looking closely to see if the provision has a use-it-or-lose-it feature or whether you can save up unused withdrawals for a future year -- therefore potentially being allowed to take out 20% in the second year if you take nothing the first.
Understanding guaranteed rates
Most annuities come with guaranteed minimum rates throughout a defined period of up to 10 years. Yet if you expect to hold on to the annuity beyond that period, you can't be sure you'll be able to match the guaranteed rate.
This has been a particularly large problem over the past decade, as falling interest rates have dramatically reduced the income insurance companies can earn from the premiums you pay. As a result, insurers have dropped annuity rates accordingly -- so once a guarantee period ends, many people have seen rates decline markedly.
Of course, this phenomenon can sometimes work to an annuity older's advantage. If rates rise over the course of an annuity contract, then what you get when the guarantee period ends could be higher than the initial annuity rate. Nevertheless, be aware of the potential for a change in how much income you get when the appropriate time comes.
High annuity rates can look attractive, particularly when other income investments pay so little right now. Before you commit to a long-term annuity contract, though, make sure you understand all the potential catches involved, and be absolutely positive you're comfortable with them.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.