Many investors have got into trouble by investing in annuities in recent years. The right annuities can make appropriate investments for some people. However, the state of the financial markets in the early 2000s caused many brokers to push less stable annuities onto people for whom they were inappropriate.
Many investors don’t understand or take into consideration that brokers are paid for selling investments.
Brokers typically receive a 2-3% commission when they sell a mutual fund. With annuities, the commission is as high as 7-10%. The broker also gets a trailer fee over time without doing anything (they do not manage the money). It is clear why brokers are tempted to push annunities even when they are not appropriate investments.
During the 1980s and 1990s many brokers got used to a high-end lifestyle from all their stock commissions. When the market declined and clients were no longer interested in buying and selling as much, they had to do something different to maintain their high incomes. Selling annuities offered them a way to maintain that income level. Some even moved client moneys into these annuities, took the huge commissions and left the industry, effectively taking a golden parachute for themselves, with others to clean up the mess.
Many investors were shaken by the slump in tech stocks that happened in 1999 through 2002. They looked for something safer to invest in. They were prime targets for brokers selling variable annunities.
Annuities were particularly attractive to people looking for a fixed income from early retirement. They thought they were getting a certain amount per year for life. Many of these investors were in for a shock when the market dropped. They ended up with a penalty interest problem and with less than half their original investment, no job, and an expensive lifestyle.
In contrast to what many investors believed, these annuities are still risky investments like stocks, but even worse, because the investors are locked into the investments because of the fees, structures and tax consequences. Owners have to pay a surrender fee to get their money out, usually the amount of the sales commission. Owners are also locked in because if a sale will results in major tax implications.
Investors were also allowed to believe that their principal was protected. This wasn’t entirely true. People were led to believe they are analagous to life insurance policies. This isn’t entirely true either.
Annuities are like mutual funds wrapped up in an insurance policy. There is usually a death benefit related to the amount of money paid in. They were often sold as a guaranteed or insured “can’t lose” policies. Annuity managers typically put the money in subaccounts of mutual funds which can be very aggressive which if they go down in value will decrease the surrender value of the product. If you invest $500K in one and the market goes down you could have a value of $250K.
You can read a case study involving the sale of unsuitable annuities here.
Another problem was brokers selling bond funds.With bank savings accounts paying in the range of 1%, brokers found investors willing to listen when they were selling bond funds that turn out to be junk bond funds and “crap annuities”. People may not know they are in a junk bond fund because they are not called “junk bond funds”. They may be called a “high yield fund” or simply a “bond fund”.
Brokers have a duty to ensure that investments are appropriate for their clients. And junk bonds funds are not appropriate for many investors. Brokers never call these funds junk bond funds, preferring terms like high-yield bond fund or just bond fund. Putting your money in them is not the same as buying a bond and is certainly not the same as putting your money in an insured bank account.