Dear Rick:
Five years ago when I retired I sat down with someone to discuss what I should do with my 401(k). They convinced me that the best thing to do would be to put the money into an annuity because I couldn’t lose money. I was also told at the time that I could take the money out whenever I wanted to. At the time I bought the annuity I was told that I would probably get around seven percent a year. Unfortunately, the return I got was less than half that. I decided that I want out of the annuity and so I called my annuity person and to my shock I was told if I close the annuity I would have to pay a penalty of 10 percent. He also told me that the penalty is in place for another five years. Although, he claims that we discussed penalties, I am positive that when he sold me the annuity it was never discussed. My brother who’s an attorney told me that if I want he would file a lawsuit but he doesn’t think much would come out of it because it’s a he said/she said case. I am going to get out of the annuity whether I have to pay the 10 percent or not. My question is, and I want you to be honest, is what mistakes do you think I made when I bought the annuity so I can avoid those same mistakes in the future?
Leslie

Dear Leslie:
One thing I can assure you is that I will be honest with you. I’m not a big fan of beating around the bush and I believe that people should expect honesty from a professional. I do believe you made mistakes and the mistakes are not necessarily buying an annuity because in certain situations annuities make sense for people. The big mistakes you made are that you didn’t do any independent investigation of the annuity  you purchased, nor did you understand the terms of the annuity before you bought it.

I’ve always believed it is important when you invest your hard-earned money to look at independent information regarding that product. When the agent told you that you would average about seven percent return on the annuity, you should have done some independent investigating to look at actual past returns. If you hasd done that you more likely than not would have discovered that seven percent was not a realistic return. As investors, we should never forget that the reason we invest money is to make money and although past returns are not always indicative of future returns, they are important in researching an investment.

The other mistake that I think you made is that you didn’t understand the annuity. If you had read the annuity contract or done some independent research on the annuity you would have discovered the penalty. I recognize that annuity contracts are not easy to understand as many of them are filled with mumble-jumble legal ease. However, as investors, before we invest our money we must understand the terms of an investment and how it works. Therefore, one of the serious mistakes  you made was not reading the annuity contract before you purchased it.

I recognize how difficult annuity contracts are to read, especially for someone who is not involved in the financial world. However, that still doesn’t relieve an investor of his obligation to understand the investment. Either you have to hire someone who can independently review the product or walk away from it. Purchasing a product when you don’t understand the terms is not an alternative.

I know some people are asking, isn’t  what the agent is supposed to do; explain the policy to you? Theoretically, that is correct; however, we also have to recognize that there is a natural conflict of interest between the annuity salesperson and the investor. The annuity salesperson receives substantial commissions on the sale of the annuity and thus, in many situations they are more concerned about their commissions than taking care of the client.

On the whole, I am not a fan of annuities with high penalties for long periods of time. These investments are great for the salesperson; they are not so good for investors. As I’ve mentioned many times in the past, there are annuities that have no penalties and have very low fees. Companies like Vanguard, Fidelity and Schwab all offer these types of annuities. Therefore, if you’re thinking about buying an annuity, before you sign on the dotted line it pays to check out some of the penalty-free annuities.

Good luck!

If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com.