Interest rates have been extremely low for a long time, and investors who need income are taking desperate measures to find it. Knowing that, some insurance companies have started to market annuities by offering annuity rates that are far higher than bank CDs and bond funds offer. Yet some of these high annuity rates come with a huge catch, and if you don't understand it, you could get caught unaware of the price you're paying to earn those rates. Below, we'll take a look at the tricky market strategies that some insurance companies use and why they're exceptionally misleading.
It's much more difficult even to get information on annuity rates than it is for other income investments. Lists of bank CDs and bond yields are easy to find, and reputable brokers offer access to wide varieties of investing options in those asset classes. Yet for annuities, you often have to rely on marketing materials that contain a lot of hype, so you have to be more careful in evaluating their claims and look out for traps.
In particular, there are two ways that companies offer inflated annuity rates. First, many annuity companies offer a short-term increase in your interest rate but then revert to a lower rate in the future. For instance, a search for top annuity rates turned up one fixed annuity that offers a first-year interest rate of 8.3%. The marketing material didn't even say what the interest rate would fall to after the first year, but it did disclose that the 8.3% included the fixed rate plus a premium bonus, or interest rate enhancement. Only after some digging would you discover that the base rate on the product is just 1.3%. On top of that, the annuity has a 10-year surrender period, meaning you would have to wait 10 years before you could withdraw funds without facing a penalty.
By comparison, another annuity promising high rates had a similar 10-year surrender term but offered a rate of just 3%. It's easy to understand why someone would pick an annuity that promises an 8.3% rate over one with a relatively meager 3% rate. But when you do the math, the 3% annuity would give you 50% more in total income, purely because the 8.3% annuity would abruptly revert to the lower base rate.
The immediate annuity trick
Another trick insurance companies pull is to list annuity rates on fixed immediate annuities. For instance, one provider said it would pay 6.1% as an annuity rate for a 70-year-old while paying 5.5% for a 65-year-old. Referring to ages for an annuity is a giveaway that the product in question is an immediate annuity.
There's nothing wrong with immediate annuities, but you have to understand what they are in order to evaluate them properly. With an immediate annuity, you pay an up-front premium, and the insurance company agrees to pay you a stream of income for the rest of your life. For instance, with the 5.5% annuity mentioned above, 65-year-olds would pay a $100,000 premium and receive $5,500 annually for the remainder of their lifetime.
The important thing to remember about immediate annuities is that in most cases, the initial premium you paid is lost upon your death. Using the example above, if you died 20 years after buying the immediate annuity, you would have received a total of $111,000 in annual payments over time, but your heirs wouldn't receive anything from the annuity. Instead, the insurance company would keep the premium.
That makes the claim of a 5.5% annuity rate a bit deceiving. In our example, your average annual return on your investment would amount to far less than 1%. It would take you 18 years just to recoup your up-front premium, and in your final two years you would earn a total of $11,000 on that $100,000 premium. If you died less than 18 years after purchasing the annuity, then you would lose money on it.
Some immediate annuities provide protection against situations like this, but there's always a trade-off. Such guarantees generally mean either higher fees or lower monthly benefits.
Be smart about annuity rates
It's easy to understand why investors are eager to get more income wherever they can find it. However, relying on insurance companies' claims about annuity rates can be dangerous. Be on the lookout for deceptive claims about annuities, and you'll be far more likely to get a product that will actually deliver on its promises over the long run.