How to read an annuity contract

In 2019 a client in her seventies brought me an annuity contract she had been sold by her previous advisor. She did not understand it. Neither, after the first read, did I. It took four months to unwind, and the previous advisor had earned 6 percent of her money on the day she signed. I have run a free workshop on reading these documents every year since. More than six hundred people have come. This article is the workshop, in writing, for the people who could not.

First, the honest frame. An annuity is a contract with an insurance company: you give them money now and they promise to give you money later, sometimes for the rest of your life. That can be a perfectly good thing to own. A simple immediate annuity that turns a lump sum into a monthly cheque for life is one of the few products that genuinely solves the problem of outliving your savings. The trouble is not the idea. The trouble is the thirty-one pages wrapped around it.

Start on the last page and work backwards. Contracts are written to be read front to back by people who will not get past page three. The things that cost you money are placed where that reader never arrives. On the last pages you will find the 'schedule' or 'specifications' page — a single sheet listing the actual numbers for your contract: the surrender-charge schedule, the mortality-and-expense charge, the rider fees, the index-cap or participation rate if it is an indexed product. Photograph that page. It is the contract. Everything else is the explanation.

Second, find the surrender schedule and read it as a sentence: 'If I need this money in year three, I will pay X percent to get it.' Seven years at 7 percent declining is common. Ten years at 10 percent is not rare. Then ask yourself honestly whether you are certain you will not need the money in that window. A roof, a hip, a daughter's divorce — these do not consult the surrender schedule.

Third, add up the annual charges. The mortality-and-expense charge is typically 1.0 to 1.4 percent. Each 'rider' — guaranteed income, death benefit, long-term-care feature — adds between 0.4 and 1.2 percent. The underlying investment funds, if it is a variable product, add their own expense ratios, often 0.8 to 1.2 percent. I have sat with clients whose total was 3.1 percent a year, on a product whose guaranteed growth rate was 2.4 percent. That contract could not win. It was designed by people who knew it could not win.

Fourth, if the word 'index' appears, find the cap. An indexed annuity promises 'the upside of the market without the downside.' The cap is the maximum you can earn in a year, and it is set by the insurer, and it can usually be changed by the insurer. A 4 percent cap in a year the index rose 22 percent is not the upside of the market. The participation rate — the share of the index gain you receive — works the same way. Find both numbers on the specifications page. If they are not there, that is your answer.

Fifth, find out what the seller was paid. Ask directly: 'What is your commission on this product, as a percentage and in dollars?' A fiduciary adviser is required to answer. A salesperson will change the subject. Commissions of 5 to 8 percent are standard on long-surrender products; the surrender charge exists precisely so the insurer can recover that commission if you leave early. You are paying the adviser's fee in instalments whether you know it or not.

Last, the question I ask every client before they sign anything: can you explain this to your children over dinner, in under two minutes, without the document? What you are buying, what it costs each year, when you can get out, and what happens if you die. If you cannot, you do not understand it yet, and an adviser who cannot help you to that two-minute explanation is not your adviser.

I spent nine years in the Navy provisioning an aircraft carrier. A plan that cannot survive contact with reality is not a plan. A financial product that cannot survive being explained to a fourteen-year-old at the dinner table is not a plan either. It is a contract, and somebody wrote it for the reader who stops at page three. Do not be that reader. Start at the back.