When equity markets dip 10%+ the annuity pitches get amplified by 5 orders of magnitude as people start exploring “alternative investments” to equities and bonds. Are annuities a viable solution, or are they simply pushed aggressively by agents preying on people’s fears to collect large commission checks?
Annuities are a bit controversial and have become somewhat of a bad word in the mind of consumers, although the term “annuity” is a very broad term encompassing many different products. For many years we have had notable financial personalities telling their audience how annuities are terrible products and are only recommended to benefit the agent selling them. One prominent registered investment advisor really HATES annuities:
On the other hand if you attend a free steak seminar from a local annuity salesman, you may walk out of there thinking you just heard about the best thing since New Coke. But much like New Coke, it’s probably due to the product being overhyped.
These extreme positions are taken to gather attention, which works well. After all, Ken Fisher ranked 151 on the Forbes 400 list and I must admit I am quite a bit lower than that.
Like most other issues the truth is somewhere in the middle of the extreme positions. Annuities are just a product with many iterations. There are good and bad annuities, and good and bad uses of annuities.
Show Me The Incentives….
Annuities have generally been tied to high commissions for the agent, and often times the worse the annuity product the higher the commission to the agent. Insurance companies have to pay large incentives for agents to push the worst products. Being that the terrible products compensated agents the most handsomely, what do you think some bad actors pushed very aggressively? The bad ones.
Most often throughout history when annuities were sold to consumers they are done so under a “suitability” standard as opposed to a fiduciary standard. The product does not have to be in your best interests, just suitable. A fiduciary standard of care requires the advice you get to be in your best interests, while the suitability standard just requires the advice or product sale to be suitable.
I find use cases for annuities pretty few and far between, but even when I have recommended them to clients I have noticed skepticism. As a reminder, Meredith Wealth Planning is a fee-only firm and neither the firm nor myself receive any commissions from product sales. I am held to a fiduciary standard of care as a registered investment advisor, and receive no incentive to recommend any single product over another. Despite that, because people have heard “annuities are bad” they are a bit fearful of the product.
While it is true that there are conflicts of interest when commission-based financial advisors recommend annuities. If you want to be sure the advice you’re getting is conflict-free, receive it from a person that does not benefit from making the sale. There are many advisory firms today that no longer accept commissions, and you can search for them on the NAPFA website.
A Useful Resource
In 2008, Larry Swedroe and Jared Kizer co-authored “The Only Guide To Alternative Investments You’ll Ever Need: The Good, The Flawed, The Bad, and The Ugly“. In it, they dive into the weeds on all types of alternative investments, including annuities. Since I agree with much of what they wrote on the topic of annuities, I’ll summarize some of their key takes below and add some points of my own. This is also a good book to check out if you have an interest in other alternative investments such as:
- Private Equity
- Venture Capital
- Hedge Funds
- Real Estate
- Structured Products
The Good: Fixed Annuities, DIAs, and SPIAs
Fixed annuities are boring. As a boring guy myself, I appreciate fixed annuities. They are not an investment. They are a contract sold by an insurance company, and the insurance company is the party that is bearing the investment risks. Therefore if an individual is not willing or able to bear investment risks, they can unload that risk to an insurance company via a fixed annuity contract. The insurance company will pay you a fixed interest rate for a fixed term, which is agreed to in advance.
Of course the insurance company thinks they can make more by investing your money than what they are paying you, otherwise why would they even offer you this deal? A fixed annuity purchaser should be okay with that, as it is the tradeoff by unloading the investment risk to someone else.
There are no expenses to buy a fixed annuity, as that is already factored into the interest rate the contract holder receives. Historically an insurance agent was paid a commission on the sale of an annuity, but now there are zero commission fixed annuity products available to fee-only advisors. The interest rate on these products can be a little bit higher since there is no commission paid to an agent.
Fixed annuity contracts guarantee a fixed interest rate for a set term length (usually 3-10 years). Another name for these today is multi-year guaranteed annuities (MYGAs). They usually have parameters in the contract that the policyholder can withdraw 10% – 15% of the balance each year without penalties, and after the term length is over you can withdraw the entire balance without penalties. The fixed annuity contract is tax-deferred, meaning you will not be taxed for the interest until you actually take money from the contract.
Further, if you take money from your annuity contract before age 59.5 then the IRS will penalize you 10% on all the accrued gains you withdrew in addition to ordinary income tax on the gains withdrawn. On this token, it’s important to note that annuity withdrawals come out as “gains first”.
Another type of fixed annuity that falls under “the good” column is the single premium immediate annuity (SPIA). Buying a SPIA is very similar to buying a personal pension, or insuring one’s longevity risk and making sure you don’t outlive your assets. You give the insurance company a lump sum of money, say $100,000, and they will pay you a fixed amount every month for the rest of your life.
One can visit Charles Schwab’s income annuity estimator here and run calculations as to what an annuity would fetch them. I ran an example below of a 65 year old male with $100,000 who wanted to start the income next month. He would be able to receive a maximum of $521 a month.
You’d essentially get $6,240 annually on $100,00, but this should not be viewed as a 6.24% rate of return. It is a 6.24% “payout ratio“. After all, for some period of time the insurance company is simply just returning your own money to you.
No need to do the math, I’ve already done it. If the annuity purchaser chooses the single life only option above it will take them about 192 months (about 16 years) to recoup their $100,000. It’s a good incentive to live longer, as you can really eat into the insurance company’s money that way. Of course there’s the risk under the single life only option that you pass away early and the insurance company keeps all your money.
To mitigate that risk, you can often select a return of premium option for a little lower monthly payment, and if you pass early without receiving your entire premium back then your beneficiaries will receive the difference back in a lump sum or periodic installments.
Let’s imagine someone moved forward with buying the single life only option above. If they lived to be 90 years old they will have received $6,240 for 25 years, or roughly $156,000. That comes out to an internal rate of return of 3.76% annually. Could you do better elsewhere? Over 25 years I have faith equities would do far better, but not everyone shares my risk tolerance and optimism. Most people I come across with pensions seem to like them, so I suspect SPIAs would be an option for some retirees as well as there are many similarities. SPIA rates are also affected by interest rates, which are still very low at the moment compared to history.
But if you’re comparing say an Illinois public pension payout to what a SPIA will fetch you, I’m afraid you’ll find the SPIA quite disappointing.
A deferred income annuity (DIA) is simply a SPIA that is not an immediate start date. You are deferring the income start date to some point in the future. Let’s rerun Schwab’s calculator above but choose a start date that is 5 years later:
Here we noticeable a sizable jump in monthly income by deferring the income start date for 5 years. After the income starts it would take 134 months (11+ years) to recoup your initial premium, not including the 60 months you deferred the income start date.
SPIAs, DIAs, and Fixed Annuities are important to shop for, I wouldn’t suspect the rates listed above from Charles Schwab are the best available. Also, SPIAs can carry a significant amount of inflation risk just like we see with traditional pension plans that do not have cost of living adjustments. Receiving $520 a month right now might sound good but it may not be so great if we see a decade plus of even moderate inflation.
I work with insurance consultants that are able to run annuity quotes from many different companies. When it is appropriate to evaluate SPIAs, we are able to find the best options.
Potential Use Cases for Fixed Annuities, SPIAs, and DIAs
The most apparent use case for these types of products would be as an alternative to fixed income instruments, or the low risk portion of one’s portfolio. Choosing to insure your longevity risk with a SPIA or DIA is a very important decision that should involve in depth planning.
The Bad: Variable Annuities (VAs)
Swedroe and Kizer state in their book that by the end of 2006 there was over $1.4 trillion in outstanding variable annuity (VAs) investments. 2006 was a long time ago, and we didn’t throw around the word “trillion” nearly as much back then. If variable annuities are so unbelievably popular, how can they be bad? Swedroe states that one plausible explanation is that the sale of VAs are not due to actual demand for the product but instead it reflects the successful efforts of commission-based salesmen.
A VA is a mutual fund like account wrapped inside of an insurance contract. VAs differ from fixed annuities in a number of ways:
- VAs often have significant underlying expenses.
- Your contract value fluctuates with the underling investment changes in a VA.
- You are able to choose how your money is invested in a VA across various subaccounts (which are very much like mutual funds)
- VAs generally have all types of bells and whistles (AKA “riders”) that can be added to the contracts.
In it’s most basic form, a VA can be viewed as a tax-deferred investment account. Just like the fixed annuity contracts, there are consequences if withdrawing funds before age 59.5. There are also often “surrender charges” on variable annuity contracts if withdrawing more than the free withdrawal amount in the first 5-10 years.
There are major benefits to investing in a tax-deferred manner, as there is no tax drag on the portfolio. It may sound appealing to someone who has maxed out all of their retirement account contributions to explore a VA for additional tax-deferred investment growth, but I’m afraid that is not the case.
Unlike a 401k contribution, a VA contribution does not go in pre-tax. Therefore there is no upfront savings from a tax standpoint, and much of the potential benefit of investing in a tax-deferred manner is eliminated by the fact that annuity contract withdrawals are taxed as ordinary income as opposed to long-term capital gains tax.
In Swedroe and Kizer’s book they cite a study done by Jeffrey Brown and James Poterba. The study assumes a long-term capital gains tax rate of 15%, and an ordinary income tax rate of 33%. Further, they assume the all in VA costs are only 0.25% more annually than a comparable mutual fund or ETF (at the time the book was published the average VA had total all in expenses of 1.65% annually, while many index funds were being offered for less than 0.20% a year). The study shows that a VA would not breakeven with a taxable investment account until year 40 of the investment period.
Given that, we would expect many non-qualified variable annuity contracts to be owned by younger investors but at the time the book was published only 4% of contracts were sold to people under the age of 35.
There are other potential benefits lost when investing into a VA as well:
- Loss of step up in basis provision
- Cannot harvest tax losses in a VA
- Cannot donate shares of appreciated securities from a VA
- Cannot use foreign tax credit if holding international equities in a VA
If you’re buying a VA simply for tax-deferred investing, you could be making a big mistake. However, there is a use case if someone has a large amount of unrealized gains in an existing expensive variable annuity contract. You can perform a 1035 exchange from your high cost annuity contract to a lower cost one, and continue your tax-deferred status. This gives you the ability to wind down those investment gains over time, maybe when your ordinary income tax rate drops.
VAs are recommended for other reasons besides tax-deferred investing, including lifetime withdrawal riders and death benefit enhancements. This is where it gets really fun!
Variable Annuity Death Benefits
What may sound like a neat feature of variable annuities is that they often come with a return of premium death benefit. What this means is that if the policyholder dies, their heirs will at least receive back what the policyholder paid in premiums (minus withdrawals). This is usually the most basic death benefit that VAs offer, although there are many more exotic death benefit riders one can add to different contracts.
Here is a hypothetical as to how the basic return of premium death benefit works:
“Sally invests $100,000 into a variable annuity contract on January 1st and the investments inside her contract decline drastically right after that. Sally gets her statement the next month and sees her contract is now worth $60,000. Sally goes outside for a walk to clear her head, but unfortunately gets struck by lightning and dies. Her heirs will receive the $100,000 she originally placed into the contract, despite the market value being far lower at the moment.”
Unfortunately a 2001 study on the value of this benefit found it only to be worth 0.01% – 0.10%, depending on the investor’s gender, purchase age, and the volatility of their underlying subaccounts. The median mortality and expense charge of VAs during the study was 1.15% annually. This means the benefit was dramatically overpriced, and as further evidence of these excessive costs only about 0.40% of VA contracts are surrendered in any given year due to death or disability and only a small fraction of those reflect losses that trigger the death benefit.
Now if you’re thinking “why don’t I have my 105 year old aunt put her entire net worth in a variable annuity that can invest in Shiba coin, because she’ll never need the money and gets a return of premium upon death even if the investment tanks and there is incredible upside if it works out well”, I’m afraid I have bad news for you. There are usually age limits on purchasing a variable annuity, as well as on the death benefit options attached the contracts.
Variable Annuity Living Benefit Riders
Swedroe and Kizer don’t really touch on living benefit riders in their book, but this contract feature has really become popular since their work was published. The most common I see is referred to as a Guaranteed Lifetime Withdrawal Benefit (GLWB). As mentioned prior, VAs have numerous riders you can often add on to a contract at an extra cost. Let’s look at a hypothetical of a GLWB rider:
Tony is 60 years old and has $100,000. He wants a lifetime income from his investment starting at 65 but would still like access to his principal balance. He consults with a financial advisor who recommends a VA with a Guaranteed Lifetime Withdrawal Benefit. The advisor said Tony’s “income base” will grow at a minimum of 5% simple interest annually, or the performance of his investments, whichever is better. He can start withdrawing 4.75% of his “income base” annually at age 65, and be assured he will never run out of money as long as he sticks to withdrawal amount. The income based is used solely for calculation purposes, and this value never declines (unless there are “excess withdrawals”), so Tony’s income will never decline.
The advisor does the math and shows Tony that at a minimum he will be able to have $5,937.50 a year in annual lifetime income starting at age 65.
This contract has a mortality and expense charge of 1.00% annually, a GLWB rider charge of 1.50% annually, and the underlying investments cost him 0.70% annually. All in, Tony is paying 3.20% annually, which is an outrageous expense….but what if he’s actually paying more than that?
The $5,937.50 Tony withdrawals annually will first be taken from his contract value, as long as there is a value there. The mortality and expense charge and the underlying investment charges are based on his contract value, so the dollar value of those fees will decline over time as Tony’s contract declines due to withdrawals.
However, the 1.50% annual GLWB rider charge is often charged on the “income base” referenced earlier. Remember earlier how the income base is used solely for calculation purposes and never declines? Therefore even if Tony’s contract value drops to say $30,000 due to a decade of withdrawals and fees, if his income base is $125,000 then the GLWB rider fee of 1.50% is based on 1.00% of $125,000. The GLWB rider fee could be $1,875 in that scenario on a contract value of $30,000, which is 6.25% plus the 1.00% mortality and expense charge and 0.70% of investment expenses. Now we’re up to nearly 8% in annual expenses.
Given he’s taking out $5,937.50 a year on top of the 8% in expenses at this point, without earth shattering investment performance this contract will certainly go to zero. So the contract value eventually becomes meaningless in this scenario and it appears that the income payout would have been higher to just choose a SPIA option.
VAs are full of BS that nearly no consumer understands. One may think “maybe I could invest the VA subaccounts ultra aggressively since my lifetime income is guaranteed, and at least then I can potentially grow my income which I cannot do with a SPIA” but let me stop you there. Many insurance companies offering these lifetime withdrawal guarantees severely limit the contract holder’s investment capabilities. Earlier in my career, one such company would even move your investments automatically if they deemed things to be trending the wrong way. From my perspective it looked like they tended to sell low and buy high, which is a nice recipe to ensure you’re never able to grow your lifetime income beyond what they want it to be.
One other way people will look at VAs with GLWBs is a way to have their cake and eat it too, since the principal balance is still there unlike a SPIA. But it’s really not there, because if you take an excess withdrawal from your principal balance outside of the GLWB amount, it will negatively impact your GLWB amount going forward. If you surrender the contract to get your contract value, your lifetime income is canceled of course. Therefore, why did you buy it in the first place? In this case a SPIA eliminates the temptation of tapping into your principal balance, as you no longer have a principal balance in a SPIA.
Often times if looking at equal ages and genders, a SPIA will generate a higher guaranteed lifetime income than a VA with a GLWB rider. The one argument to be made for VAs with GLWB riders is that there is the potential to grow your lifetime income that cannot be had in SPIAs.
What a consumer should look for in this product realm would be a lower cost mortality and expense charge, lower cost subaccounts, and an annuity company that does dictate how you allocate the money in the underlying subaccounts. While you will still pay much more for this product than you would a comparable investment account, there would be a floor on your lifetime annual income guarantee and you’d still have the potential to grow it.
The UGLY: Equity-Indexed Annuities (AKA Fixed-Indexed Annuities)
Victor Lustig sold the Eiffel Tower twice, despite never actually owning it. If he were alive today I suspect he’d be peddling equity-indexed annuities in some conference room of a fancy Italian restaurant, or maybe he would have launch a cryptocurrency called LustCoin (sounds good to me). Let us dive in.
Whether or not you were born with a good BS detector, the following phrase should set off some alarms in your head:
“You can receive the upside of the stock market with zero downside”
That sounds like the “you can eat anything you want” diet, and works just as well too.
An equity indexed annuity usually is a 5 – 15 year commitment, and credits you interest annually based on the performing of an underlying index like the S&P 500. There is actually an element of truth to the quote posted above. Generally the annual return floor is 0%, meaning you cannot earn a negative return during a contract year. There is also usually a cap, and more recently I have seen that to be in the 6% range.
In that situation, if the S&P 500 earned 15% in a year you would receive the cap of 6%. If the S&P 500 lost 15% then you would get 0% for that year.
That doesn’t too ugly yet does it?
Here’s the thing about the cap rate, they can change it during your contract. If you read the fine print, it will say something to the effect of “The initial cap rate is 6%….the guaranteed minimum cap rate is 1.00%”.
This cap rate could be changed each year to the preference of the insurance company. One may start with a cap rate of 6%, but by year 2 it could be far lower than that.
The agent selling the product may tell you it’s no big deal and will never happen, but it’s in the contract for a reason. Or maybe they’re counting on you never even asking about it, who reads the fine print anyway? The only people that would do such a thing are the same ones that have made it this far in a 4,000+ word blog post about annuities!
If that isn’t bad enough for you, let me tell you about “participation rates”. An equity indexed annuity may state the annual cap rate is 6% but your participation rate is only 75%. What does that mean?
Say the S&P 500 earns 6% during the year, you think you’re getting the full 6% interest (assuming that is your cap) credited to your contract. Unfortunately you’re only getting 75% of that, because that is your participation rate.
Like the cap rate, the participation rate can change year to year as well. They could throttle that down to say a minimum of 25% participation if they’d like. Suddenly the potential returns of the product you purchased are entirely different than what you signed up for.
Of course there is the belief that you cannot lose money in an equity indexed annuity contract, but many of the riders mentioned above for variable annuities can also be tacked on to equity indexed annuity contracts. In scenarios like this I have seen rider fees exceed the interest credited each year and the client has ended up losing money over time.
If you are exploring equity indexed annuities I think it would be best to do extensive research on what the minimum cap rates, participation rates, and surrender charge periods are. Avoid free dinner presentations. It could be the most expensive dinner you’ve ever eaten.
Disclosure: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.