As the age-old saying goes, the best way to learn is by scraping your knees a few times. Regrettably, these learning lessons can be quite a bit more painful when they are the result of not-so-great financial decisions. Whether you made the decision to buy-in to a timeshare or an annuity, you may have been painted a picture. Despite both seeming like a great deal, they are only a winning option for a very small portion of the population. From high-fees to very little flexibility, avoid the scabs.
First Off, What’s an Annuity?
According to Investopedia, annuities are financial products that pay out a fixed stream of payments to an individual. Annuities are created and sold by financial institutions, which accept and invest funds from individuals. Upon annuitization, the holding institution will issue a stream of payments at a later point in time.
In clearer terms, annuities start off in the same way other investment accounts start: you put money into it and then you can go invest it. In an annuity, you put money in that can (generally) be invested. But as opposed to a regular investment account, an annuity has fees (also known as riders) attached to it for various features. Fees typically include commission, investment expenses, administration fees, mortality expenses, distribution charges, contract fees, underwriting fees, and redemption fees
How Do They Work?
Since they are sold by insurance companies, they provide a yield for the holder of the fixed annuity by using the money to generate an investment return on those invested assets. The insurance company holds back a small portion for itself, called an interest rate spread, and passes the rest as the return. That interest rate spread should matter to the annuity holder because the company is essentially extracting a very high fee from the return being generated by the annuity owner’s funds.
Example: You put $500,000 into an annuity and are getting $22.5k a year from the annuity “for free.” What has actually happened is that the insurance company invested your $500,000 into a bond that yields 5%. They keep $2,500 for themselves and you get $22,500 instead of the $25,000 that bond yielded. Out of those $22,500, you’ll likely be charged a few of the fees mentioned above… which is how you could end up receiving 3-4% less.
Asymmetry of Information
When you are sold a timeshare, you’re promised an idyllic investment in your future vacations. A timeshare is a property, typically in a resort condominium development, where you acquire the right to use a unit during a specific amount of time per year. However, when signing the contract, you never actually own the property and often times are unable to book your property during the week you want to use it.
With a timeshare purchase, you may end up having to spend more over the long term for unexpected fees, such a yearly maintenance fees. Similarly, the fees for annuities are pretty high for what you may be receiving in return. Plus, there are five different types of fees associated so it can quickly get confusing. For example, someone selling you an annuity may say, “we guarantee this account won’t lose money.” However, that feature costs 2.5% a year. While that guarantee seems like enough of a reason to put your money in an annuity, there is often great asymmetry of information.
Hidden Fees and Tight Commitments
In this market, the “guarantee of not losing money,” a common annuity sales pitch, can feel like a big perk. The market goes up and down, so it can be scary for someone that while one year it can be 15%, the next it can be -15%. With an annuity, a person may prefer to pay 3-4% in fees (so they only get 12%) and have no losses. If they are very risk averse and refuse to invest in the stock market, the annuity could make sense. The issue there is that if that individual were to stick it out during market fluctuations, they’d be better off because the stock market statistically goes up over time.
When you do the math, you come out behind versus if you were to simply invest over time. Additionally, both timeshares and annuities are essentially contracts, often of 10 years or more. For either one, you’ll face high surrender fees if you want out prior. On average, the surrender fee is around 15% of your investment!
Control of Your “Investment“
You can consider an asset an investment when there is an expected benefit, or return, for you or loved ones. Whether its an annuity or a timeshare, the benefits look great on paper but when you dig into the details, there is little to no flexibility. When you annuitize, you lose a lot of control over your money and ultimately may not be able to leave your “investment” to you children or beneficiaries.
Some people may obtain an annuity if they need additional tax savings beyond IRA/401k and don’t have estate needs. Often, annuities then have the advantage of “annuitizing,” meaning that you can turn the investment into a stream of income that pays for life; however, you lose control of the money itself. For example, say it pays you $1000 a month for life. That sounds like a great deal! But, you can no longer touch the original amount you invested. Typically, the payout is 20 years, so an annuity may be a reasonable option only if you don’t expect to need the money anytime between now and year 21.
Flexibility is one of the biggest things lost if you hold either of these “investments”. A timeshare in Miami seems like a great vacation deal, but then you realize the only dates available are during hurricane season. There’s going to be a day where you want to remodel your house or buy your grandchild their first car and simply won’t be able to, despite knowing you have the money to do so.
If someone is selling you something that sounds too good to be true, its reasonable to wonder “what’s in it for them?” Be it annuities or timeshares, it is more than likely the person selling will be receiving a hefty kickback. An “advisor” that sells you an annuity will make, on average, around 7-8% of commision. Say you put $100,000 in an annuity. You’ve actually just invested $92,000 and you’ll need to make an additional $8,000 in returns just to break even, while the salesperson walks aways with your $8,000 for doing nothing.
What Makes Sense for You?
Annuities are generally not the wisest investment choice, but they may make sense for you. With timeshares, it’s the same exact thing! Folks that get stuck in a timeshare expect to be able to enjoy the 4th of July in Cancun, without realizing that it’s often been reserved with a lot of time in advance. For a small few, it might work out. But for the majority, it’s not something they will actually be able to use. In theory, when you are presented with an annuity it sounds like something you’ll use and that reaps lots of benefits. But you are better off just buying a hotel for the Fourth or investing with a financial plan that is designed with you in mind.