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The Honolulu Advertiser
Posted on: Monday, May 30, 2005

Annuities may carry pitfalls

By Deborah Adamson
Advertiser Staff Writer

Frances Kim, a 79-year-old retiree from Kane'ohe, said her insurance agent told her a sad story of single motherhood and failing health, and Kim wanted to help. When the agent also told her how her investment would grow over time, she bought an equity indexed annuity.

Kim says when she bought the annuity she didn't know that most of her money would be tied up until she turns 94. To cash out, she could lose 25 percent of her principal in the first six years. The penalty does not fall below 10 percent until she's 92.

"When someone gives you a good story, I just take their word," said Kim, who filed a complaint with the state against the agent and her insurance company in October. "She kept making me feel sorry for her. She acted like she was my friend."

Kim's complaint is one of several being investigated by the state following allegations that annuities were sold without full disclosure of possible pitfalls. The state Office of Consumer Protection has filed a lawsuit against agents and brokers and their insurers — including Standard Life Insurance Co. of Indiana and The Williams Financial Group in Dallas — for such behavior.

"It is a significant problem," said Insurance Commissioner J.P. Schmidt. "We have seen a number of instances of variable annuities marketed to the elderly where it doesn't appear to be a suitable product for them because of their age and penalty upon surrender. The selling licensee has a duty to fully explain the product ... and that the product is suitable for the individual."

Annuity buyers such as seniors should watch out for contracts with long lock-in periods and high fees, he said. For example, it's not appropriate for an octogenarian to buy an annuity that won't mature for 20 years and carries a stiff penalty for early withdrawal.

Insurance contract

An annuity is an insurance contract in which you pay a lump sum or make regular premium payments in exchange for investment growth and a guaranteed payout for a set period of time or for life, among other benefits. The primary appeal of annuities is that you cannot outlive your income.

"Annuities in and of themselves are a good product. It is when they are inappropriately used, we get into situations like this," said Martin Arinaga, past president of the Honolulu chapter, National Association of Insurance and Financial Advisors.

There are fixed and variable annuities. Fixed annuities set a minimum percentage you will earn annually, but returns can be lower than variable annuities, which are pegged to the performance of securities such as stocks and bonds. There also are annuities that carry features of both fixed and variable products.

Let's say a couple, both 55, invests $50,000 in a fixed annuity that guarantees a minimum return of 3 percent. At the end of 10 years, their assets will grow to at least $67,200. At that balance, the monthly income would be $372 for life if rates remain the same.

A 2004 study by the Securities and Exchange Commission and the National Association of Broker Dealers showed that many sellers of variable annuities did not fully disclose various fees, risks and tax consequences of the product. Some were sold to people who couldn't afford to buy them without mortgaging their homes.

Regulators are looking into "a large number" of complaints from individual investors about annuities, according to the Securities and Exchange Commission.

"The findings of these examinations show that many firms should take steps to improve their practices," said SEC Chairman William Donaldson, in a statement. Sellers should "ensure that the securities they sell are appropriate for the individual investor."

Withdrawal penalty

Earlier this month, Gary Yokoyama of Honolulu filed a lawsuit against Midland National Life Insurance Co. of Sioux Falls, S.D. on behalf of his mother, Leatrice. In 2003, a Midland agent sold annuities to Leatrice Yokoyama's 83-year-old husband, who was functionally deaf.

The husband died 20 months later, but the widow, now 83, was stuck in an annuity her husband bought for her that would not start paying out until she reaches 100. There is a 10 percent penalty for withdrawing the money in the first six years. The charge drops off in the seventh year and disappears after a decade.

"This is absurdly unreasonable," said Gerald Clay, Yokoyama's attorney from Clay Chapman Crumpton Iwamura & Pulice in Honolulu.

Midland is charged with violating Hawai'i's "Unfair and Deceptive Trade Practices Act," according to the lawsuit. The insurer "has failed to include in its standard form annuity contracts, sales illustrations and related marketing materials all material facts necessary" to inform prospective customers who are seniors about "the true risks and unsuitability of these products," the complaint alleges.

Midland did not make a comment in time for publication. Standard Life and Williams Financial did not return calls for comment.

Investors usually can withdraw 10 percent of their principal every year without a penalty, but gains will still be subject to taxes. You can also back out of most annuity contracts within 10 days.

With annuities, consumers have to know the surrender period and the surrender charge. The surrender period is the length of time in which the investor pays a penalty to withdraw more than 10 percent of the capital. The surrender charge is the percentage to be paid.

Consumers should consider maxing out on other tax-advantaged plans first before annuities.

"For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity," according to the SEC.

Many catches

Amanda Walker, an editor at Consumer Reports Money Adviser magazine in Yonkers, N.Y., said that's because "there are often so many catches involved (with annuities). They often come with high fees and painful withdrawal penalties, for example."

The average variable annuity charges fees equal to 2.34 percent of assets a year i that's $2,340 annually for every $100,000 invested — compared with 1.47 percent for mutual funds on average — or $1,470 per $100,000 invested, according to Consumer Reports.

In addition, annuities can charge an average 1.4 percent more a year in "mortality and expense risk" fees. Moreover, if you take your money out within the lock-in period, which could last as long as two decades, it could cost you anywhere from 5 percent to 20 percent of your money. You also may have to pay underlying fund expenses.

But the basic rule of thumb when investing is "don't buy anything you don't understand," said Michael Schulman, member of the Elder Care Prime Plus Task Force at the American Institute of Certified Public Accountants.

Reach Deborah Adamson at dadamson@honoluluadvertiser.com or 525-8088.

• • •

Take precautions before buying

What to ask

• What is the surrender charge and period?

• How will it be invested?

• Any guarantees and how much will it cost?

• How can I take it out?

• How strong is the company financially? (Check with rating firms such as A.M. Best at www.ambest.com)

• Do you trust the agent or broker you're buying from?

What to avoid

• Promises of high returns, such as over 8 percent guaranteed, which is unrealistic.

• Surrender period of more than 10 years.

• High surrender charge, in the double-digits.

Sources: Consumer Reports, Michael Schulman, Elder Care Prime Plus Task Force at the American Institute of Certified Public Accountants, Internal Revenue Service

Don't be misled

Here are examples of misleading marketing pitches by some sellers of annuities:

The hook: With an equity indexed annuity, you can participate in the stock market without risking the downside. People believe they will get the money when the market goes up, but not suffer losses when it goes down.

The full story: You can, but only after paying a lot of fees. Moreover, you only get a portion of the return, say 50 percent or 80 percent. These guarantee a return, but usually it's low, such as 3 percent and not on 100 percent of your money.

The hook: You get guaranteed income for life

The full story: It may not be enough to live on. What you get from a variable annuity depends on the return of the underlying investments. If the investment performance is bad, your income will go down. If you buy an annuity that guarantees that you at least get your original money back, it's usually costly. But once you start getting payments on either fixed or variable, you cannot cash out your principal.

The hook: You don't pay taxes until money is withdrawn

The full story: While it's true that taxes are deferred, once you do withdraw you could be subject to higher taxes than other retirement investments. Long-term gains in stocks or mutual funds are taxed at 15 percent but annuity gains are taxed as ordinary income i as if you're still working. A couple filing jointly and making between $59,400 and $119,950 this year would be in the 25 percent tax bracket. Also, if you inherit an annuity, you may have to pay higher taxes on the gains than if you inherited a mutual fund.

Sources: Consumer Reports, Michael Schulman, Elder Care Prime Plus Task Force at the American Institute of Certified Public Accountants, Internal Revenue Service