Q&A: Fine Print on Annuities

Question: Two companies advertising on TV and radio promise you a $7,000 up-front payment plus a guaranteed 7% per year if you invest $100,000 in an annuity product. What’s the catch? If it’s not legitimate, how can this be advertised?

Ric: I am not familiar with those particular commercials, but based on your description I can tell that the products they are pitching fall into the category of what’s called a “bonus” annuity.

Broadly speaking, there are two kinds of annuities: fixed and variable. A fixed annuity gives you a fixed rate of return; it looks and acts like a bank CD. A variable annuity lets you invest in the product’s “subaccounts,” which look and act like mutual funds; the return you get varies according to how these investments perform.

Some people prefer the fixed annuity because it offers a guaranteed (albeit low) return. Others prefer the variable annuity because it offers the potential for higher returns (albeit at higher risk).

Now, to your point: To increase sales, some insurance companies offer a bonus if you buy their fixed annuity. In your example, the company is apparently promising a one-time payment of $7,000 (or 7% of the $100,000) to get you to invest. That’s appealing, considering bank CDs are paying about 1% these days.

But here’s the fine print: To get the bonus, you typically must agree to leave your money invested for 10 years. If you do, the bonus is credited to you at the end of the 10-year period. Thus, you don’t enjoy any compound growth on that bonus for the entire 10 years. (Getting $7,000 today is of far greater value than getting $7,000 in 10 years.) And if you withdraw any money from the account during that time, you never get the bonus — and you will pay a surrender charge of as much as 10%.

But let’s assume you do keep your money invested for the full 10 years. To protect itself from having to pay you that bonus, the insurance company provides you with annual interest on your money that is very low — say, 0.7% less than what you could get elsewhere. Over the 10 years, that reduced interest rate is how the insurance company is able to give you 7% in the 10th year. And if you decide during the decade that you don’t like the low rate you’re getting and withdraw your money — well, that means you’ll lose the bonus and incur that penalty I mentioned.

Still sound like a good deal?

Now let’s talk about that guaranteed 7% annual return. What the ad might not have emphasized is that it might pay 7% over the life of the contract — not annually. Yes, the return they are offering might not be an annual return but a total return. In other words, if you keep the annuity for 10 years, you may have earned a total of 7% — not 7% per year.

Don’t assume something is legitimate merely because of a TV or radio ad. Why do broadcasters allow such ads? Because too often they care only about the advertising dollars. Also, it’s not their job or within their area of expertise to evaluate ad claims. They don’t evaluate claims that Coca-Cola is “refreshing” or Colgate toothpaste is “doctor recommended.” It’s the consumer’s job to verify — and that’s why you did the right thing by checking with me before you plunked down $100,000 based on a 30-second sales pitch. You knew it sounded too good to be true.

Originally published in Inside Personal Finance August 2014.

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