Last week a family friend asked me to review her grandmother’s annuity contract, because my profession is in the realm of contract negotiations, and I nerd out on reading dense legal documents on the daily. The conversation went something like this, “Hey my mom says my grandma gets these checks every quarter for like $2,000 because of something called an annuity. Can you look at it and tell us what it’s about? We have an 8-inch stack of documents that hurt our head to read.”
Being a financial nerd, and not knowing anything about annuities, I took the opportunity to learn about this investment vehicle. I was shocked by what I learned, and wouldn’t suggest them for anyone. In my opinion, it is another fancy tool used by financial advisors to rob the uneducated, especially the elderly, while pretending to work in the best interest of the client.
Two years ago when I started to educate myself on real estate investing, I turned to one of my good friends to teach me how to find and evaluate distressed properties as he had built up a portfolio of seven rentals across Southern California in just five years. I offered to help him rehab properties that he purchased for free, and in return, I would be able to assist him in researching local markets, evaluating properties, driving neighborhoods, calling sellers, etc.
Want to know the first thing to told me about investing? “Rule number one, DON’T TRUST ANYONE! Rule number two, DON’T TRUST ANYONE! Do you need to ask me what rule number three is?”
The next week we were rehabbing one of his properties and he told me that he had told the neighbor he would fix one of the shingles on the neighbor’s roof. I thought it was a little funny, but my buddy is a super friendly guy so I didn’t put it past him. I climbed up on the neighbor’s roof with a bucket of tar and patched the shingles that were coming up. When I went back to our property I found my buddy curled over on the floor laughing his ass off. What was rule number one? DON’T TRUST ANYONE!
What is an annuity?
An annuity is a contractual agreement between an individual and a company in which the company promises to pay a fixed sum of money each year, typically for the rest of the individual’s life. Sounds too good to be true? That’s because it is!
By reading through the 100+ page contract and associated paperwork which turned out to be redundant information presented in different formats to confuse the hell out of most people, I learned that my friend’s grandma had purchased a 20-year immediate payment annuity. Grandma was 81 years old when she purchased the annuity, and the 20-year term of the contract “coincidentally” aligned with the potential maximum life span of grandma, as it is very unlikely she will live to 101 years of age. If grandma passed before the end of the term the remaining principal would be returned to the heirs.
Here is how I think this piece of garbage, retirement investment was sold to her by the annuity sales rep. “Hey, wow you’re old and you don’t know anything about investing? I see you have a bunch of money sitting around not working for you. Let me tell you about this magical product I have called an annuity. For the simple price of…How much did you say you have in cash? Oh, $150k? Wow, what do you know that’s just the right amount of money to qualify for an annuity which will pay you money for the rest of your life! For that price, we can invest your money for you and guarantee to pay you $9,200 a year, guaranteed forever! This way you will never have to worry about running out of money and becoming a financial burden to your children! Oh you’re old, don’t worry about the complicated math and this 100+ pages of legal contractual documents, just ask me all the questions and I’ll tell you everything you need to know (even though I won’t be held liable for anything I say that conflicts with the written contract).”
Grandma purchased an annuity contract for $150,000 with the promise of a 2.5% rate of return. The funds would be distributed through quarterly payments of $2,300 ($9,200 annually). I calculated this to be a 6% withdraw rate on her $150k investment. So the agreement draws down on the principle at a higher rate than the investment rate of return.
Now a 2.5% rate of return is about the same as sticking your money into bonds. The difference between a bond and an annuity is that with a bond you are in control of your money, however, your principle is tied up for the term of the bond. You receive regular interest payments and at the end of the term, your principle is returned in full. With an annuity, you give up control of your money to a company who then spoon feeds you back your own principle along with the contractually agreed upon interest. In essence, they delay the rate at which you run out of money over time.
Here’s a chart to show what grandma’s $150k with a $9,200 per year annual withdraw looks like with and without the annuity investment. As you can see the annuity delays running out of money for 4 years.
Now notice I said earlier that with an annuity you give up control of your money in exchange for a guaranteed annual 2.5% rate of return and a fixed sum of annual payments. Do you really think the company grandma contracted with invested in a safe portfolio only making a 2.5% return? Hell no! Let’s be conservative and assume the company is investing the principal in a mix of stocks and bonds and making a conservative 7% rate of return. The red line in the below graph shows their total profit over time. I estimate the company will make close to $91,844 off of grandma over the full 20 years of the contract term while providing grandma with only $45,667.75 in additional income. Not such a good deal huh? I bet that the company did better than a 7% rate of return and will make a killing off of grandma that exceeds the red line depicted below.
As I was reading through the annuity contract, I started thinking about what grandma’s investment would have looked like if she had invested her money in VTSAX and continued with a $9,200 a year withdraw rate. Grandma invested a year before the market crash and would have felt the full force and the recession on her investment value, but she would have still been able to withdraw funds as she needed and come out on top. In the graph below I used the historical VTSAX yearly return history for 2007 to 2016 and a conservative 7% rate of return for 2017 onward. Notice that grandma’s funds never reached back above her initial investment, that is because she withdraws 6% of her principle year after year indefinitely
I also looked at a less conservative but highly probable annual rate of return of 10% for years 2017 onward which shows that grandma would have recouped her principle by her 101st birthday while withdrawing $9,200 per year. This would have been a great nest egg for her to leave to her children.
The annuity wasn’t necessarily a bad decision when compared to sitting on cash, but it was far from the best investment option. What upsets me the most is that the company selling the annuity knows this and intends to profit the most from the contract rather than its customer. I explained the above charts to my friend and her family members so they could understand what the annuity was, how it helped their grandma delay running out of money, but did nothing to retain her money to allow her to pass along money to her heirs. They then asked me what they should do and if there were any options available to change the annuity.
Within the 100+ page contract I reviewed the termination clause and found that grandma could cancel her contract at any time, but if the contract was terminated before the January 1st of year 11 of the contract she would have to pay significant penalties. If she canceled the contract in year 1 she would have to pay a 10% penalty calculated off of the original $150,000 principle. In year two the penalty was reduced to 9% of the $150, year 3 8% of the $150k, etc. Since we are currently in year 10 of the annuity contract which carries a 1% penalty, I suggested they run out the remaining months and then cancel the contract on January 1st, 2018.
My recommendation was to move the remaining principle to a low fee total stock market index fund like Vanguard’s VTSAX admiral shares. Assuming a 10% annual rate of return, grandma should be able to defend her remaining principle from further erosion while maintaining a $9,200 a year withdraw rate.
I also went one step further and made an assumption that grandma dies at the age of 98 to show the family that if they left the money alone after grandma passes, the compounding interest at a 10% annual rate of return, they would eventually recoup the money that was lost over the previous 15 years.
In my opinion, annuities are a horrible option, although they are better than sitting on cash, you are essentially handing your money over to a for-profit company who is going to make tens of thousands of dollars off of your money while sharing a very small piece of the profits with you.
An annuity is essentially a contract where an individual gives a company a low interest loan for a defined term with no collateral, in this case, 20 years at 2.5%. The company is allowed to invest the money any way they see fit to make a profit. I would love to have a bank give me an unsecured $150,000 loan at 2.5% interest with no financial contribution on my part and allow me to invest the funds anyway I want, wouldn’t you? That’s pretty much what happens between the parties of an annuity contract. It is only a good deal for the party who controls the money.
Companies pitch annuities as a guaranteed way to maintain a steady income stream in perpetuity, but the reality is they have identified the probability of how much longer the client has to live and they purposely tie the term of the annuity to coincide with the client’s lifespan, rounded up to the closest 5 years. Annuities are no an indefinite money making machine, they only delay how long the funds will last an individual.
Don’t be fooled by financial advisors in nice suits. Take the time to do your own research and ALWAYS read a contract in its entirety no matter how long it is. You can always negotiate terms and conditions before signing a contract, however, once you have signed a contract it is a binding agreement.
Do not believe oral promises given to you by a company, if it is not explicitly written in the contract it is not part of the contract. Parties to a contract are not obligated to follow through on any promises not written in the contract.
If the wording in a contract is too difficult for you to read, ask that the terms and conditions be re-written using simpler terminology. You can also hire a lawyer or contract professional to read the contract and explain every single paragraph to you.