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By Christine Benz | 03-28-2014 12:00 PM

Beware These Annuity Pitfalls

Annuity investors must take care to fully understand their contracts before letting multiple obstacles diminish their income potential.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors who own annuities don't always know what they own. Joining me to discuss some of the key pitfalls confronting annuity owners is Mark Cortazzo.

Mark, thank you so much for being here.

Mark Cortazzo: It's a pleasure.

Benz: Annuities are among the most complicated financial products. I think a lot of consumers are really confounded when they try to analyze either an annuity they're thinking about purchasing or maybe even one they already have. You say, the current landscape and the types of products that are being issued today are actually pretty conservative; insurers are really trying to protect themselves. Let's talk about what you mean by that.

Cortazzo: Some of the legacy contracts, ones issued prior to '08. We had a higher interest-rate environment; money markets were paying 4.5%, 5%. So risk-free rates of return were higher, and the perception of risk was very different prior to 2008 occurring.

With the current products, the insurance companies have dialed up costs and made investment restrictions greater. And also the payouts are more conservative. What they're benchmarking against is also a lower rate of return, but that shift has been a pretty consistent one since the end of 2008.

Benz: Consumers may also be constrained in terms of their asset-allocation choices. Let's talk about what's going on there.

Cortazzo: Absolutely. There are only so many levers that you can pull to protect yourself if you're an insurance company. You can raise fees, and there is only so much threshold of pain people are going to take there. You can restrict how people can invest.

Some of the older contracts, ones that I even own, have no investment restrictions. So you could've put all of the money into a small-cap fund or into an international fund or be a 100% invested in equities. Many of the programs now may require 30%, 40%, I've seen as high as 50% of the portfolio to be in conservative fixed income, which is going to curtail your upside.

Some of the other things that they're able to do is use volatility restrictions. This is where as volatility in the equity markets increases, they can shift you to a more conservative mix reactively or even move significant pieces of the portfolio out of the market. They're trying to protect these against a severe downturn.

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