The Problem With Annuties – Part 2
This is the second of our two part white paper on the problems with annuities. In part I, we provided a brief, general overview of annuities. We then went into details on specific product categories, such as variable annuities and equity indexed annuities. Lastly, we discussed the problems of using a tax deferred investment product such as an annuity in a tax deferred account (yes, we know, it makes no sense but if that is where the money is, the salesman is going to propose buying the product inside a tax deferred account).
In Part II, we will discuss a number of other problems we have with annuities, including the current industry trends, income annuities (which we like) vs. guaranteed lifetime income products (which we do not like) and lastly, our opinion that buying an annuity is not addressing the real problem for many individuals – the lack of an investment and spending plan.
Current Industry Trends
Market volatility and the current low interest rate environment are factors impacting the annuity industry. The combination of these two is making it difficult and expensive for annuity carriers selling products with living benefits. Many carriers have taken steps to hedge their costs or scale back their annuity business. Living benefits, or more specifically guaranteed lifetime withdrawal benefits, is a rider (i.e. feature added for additional cost) that offers downside protection through lifetime income and upside potential with “step ups” based on market performance. We will go into some more detail on guaranteed lifetime income benefits later in the article.
Two big annuity carriers in fact have left the market – Genworth (January 2012) and Sun Life Financial (December 2011). In addition, other big players including Jackson National Life Insurance Co., MetLife and Prudential have either eliminated attractive living benefits or are “derisking” the investment options of such products. John Hancock announced in late 2011 that it would withdraw a number of annuity products (including variable annuities) and reduce its distribution channel to just a handful of broker dealers.
Another impact of the current environment is lower “crediting” rates on fixed and indexed annuities – the costs to the carrier are becoming too great, impacting their profits (make no mistake – the name of the game for the insurance company is to maximize profits on these products).
The current, low interest rate environment, however, will not impact carrier profits immediately. It will be a gradual process (which is already occurring because of how long the Federal Reserve has kept interest rates low) and take some time before the impact is felt on the insurance company reserves. In addition to the lower interest rate credits noted above, another possible impact over time would be (gasp!) lower commissions paid to agents.
Given the “Obamacare” tax law changes that are in effect for 2013, we believe the salesman will talk more about the tax deferral aspects of annuities versus the withdrawal benefits. This is the way it used to be before the recent product innovations but even the tax deferral aspects have a downside relative to investments made outside of an annuity wrapper. For example, annuity withdrawals are taxed as ordinary income, which includes any appreciation of the underlying investments. Appreciation of an investment made outside an annuity is taxed at a preferential capital gains rate (as long as the investment is held more than one year). Conversely, losses inside an annuity product are not tax deductible versus investments made outside the annuity, which allow a capital loss deduction.
One way carriers are scaling back is the reduction of the income benefits. MetLife announced that starting in early 2012, it was reducing the rate to 5% from 5.5% on its products.
As we noted above, the life insurance company is in the business to make money and the more benefits they add to products, the more costly the product is to the insurance company. Higher costs equate to a lower rate of return. Several insurance carriers today are attempting to buy out the promises they made on annuity contracts issued as noted by Bloomberg and The Wall St. Journal.
Income Annuities vs. Guaranteed lifetime withdrawal benefit (GLWB) annuities
We think annuities make sense in certain planning situations when the individual needs a guaranteed income stream. The simple, immediate annuity can be an excellent product. However, the GLWB rider has become very popular, promoting income protection (or income payments) with equity market participation. However, a variable annuity with a GLWB is expensive and very difficult to analyze and compare to other GLWB annuities.
As an example of the complexity, let’s compare these two products.
An individual can purchase an inflation adjusted, immediate annuity. The pro of this product is the providing of the needed income and reduction or elimination of the risk of outliving one’s savings. The cons of this strategy are lack of control over the funds, lack of liquidity, lack of flexibility and the inability to leave a bequest to heirs.
An individual could also purchase a GLWB annuity. This product does allow for control over funds, ability to invest in equities, has liquidity and flexibility. However, as of the date of this paper, the products do not have an inflation guarantee. The salesperson may explain that this is where the guarantee comes in, as the income payout rises if the account value increases (through returns and if returns exceed withdrawals). However, what they do not say is that this mechanism falls short of inflation per a 2007 Ibbotson study. That study notes that the estimated increased payout averages 1.35% while inflation has historically averaged 3%.
The GLWB is more popular than the immediate annuity, we think, because of the sales hype. The sales literature we see and discussions we have had with individuals pitched these products is that they are the “holy grail” – they provide stock market participation to the upside with downside protection. When we drill into these contracts (which individuals typically do not do), however, we note that the high fees of the GLWB product takes a substantial bite out of the equity returns. There is no “holy grail” here and you cannot have your cake (enjoy equity like returns) and eat it to (hedge downside risk).
Joe Tomlinson recently published a study comparing an immediate annuity (with a cash refund feature) to a GLWB annuity and a traditional 65/35 (stock/bond) index based portfolio. His study reports that a major difference in these three options for retirees is the expected bequest values. He noted that the lower bequest values for the two annuity products was directly related to the fees for the guarantees (the 65/35 portfolio had the higher bequest value). Our take away here is that guaranteeing an income that lasts for life requires a significant sacrifice of expected bequest values to the heirs. This is a topic that the annuity salesperson does not seem to bring up when pitching their product and many people that we talk with have a desire to leave something to their heirs. His study also notes that the bequest values for the GLWB product decline over time, relative to the immediate fixed income annuity. It should also be noted that in his study, he used a very low cost Vanguard GLWB product. The Vanguard product had a .95% annual GLWB fee and an average of .59% for other annuity and investment management fees (we should note that this is an excellent product and is not promoted by commissioned annuity salespeople since no commission is paid) or a total of 1.54%. Using a more traditional, commissioned agent product (3.50% fees or double Vanguard), the result is what you might imagine – lower income withdrawals and lower potential income increase over inflation (.66%). Interestingly, the higher cost GLWB product resulted in a lower bequest value than the Vanguard product (which was higher than the immediate annuity, lower than the 65/35 portfolio). The take away – if an individual needs a GLWB product, the lower the expenses, the better. His study also notes, however, that because the income payouts of the higher cost GLWB is similar to Vanguard, the buyer may not know or be made aware of the much lower bequest value. We do not think that today, the commission driven annuity sales force will do the right thing, putting the client first and move prospects who value the bequest to a product like Vanguard. It will be up to the independent, non-commissioned firms to do so.
Value of the Guaranteed Lifetime Withdrawal Benefit versus a Proper Investment and Spending Plan
Wade Pfau, noted author, recently published a study on this topic. In his recent study, he discusses the prospect that individuals selling annuities may be overvaluing the guarantees (or maybe they are purposely focusing on the guarantees to the potential buyer?) versus the impact of inflation on the income stream over time (money illusion in behavioral finance jargon).
He comments in his study that the non-inflation guaranteed payments have been worth little when comparing to rolling periods of historical US market returns. He also notes that a traditional portfolio, using historical returns, could replicate the guaranteed product withdrawals (without the fees, riders, etc.). Another underappreciated concern, if the salesperson is focusing on lower expected returns going forward given the current economic environment (not previously experienced), would be the financial strength of the insurance company to pay the guarantees! If we are moving into to new environment of lower returns (does not look that way given equity returns since 2009), due to economic problems not previously experienced, shouldn’t there also be concern that the carrier will not be able to live up to their promise either, given the unprecedented future?
The bottom line of his study is that retirees may find “peace of mind” from the GLWB guarantees. An unintended consequence of the guarantee may in fact be that it stops a retiree from panicking and selling stocks after a market drop. However, the money illusion issue (i.e. retiree not appreciating the impact that inflation will have over time to a stated withdrawal value that sounds good at the time of purchase) is not being properly considered. Moreover, current GLWB products, due to their high fees and costs (see discussion above) rarely provide inflation protection (especially during periods of poor equity returns). The higher fees erode account balances more quickly, allowing for fewer account step ups and more exposure to inflation risk (exactly the opposite of the goal of purchasing the product). A proper investment and asset allocation plan, coupled with a proper spending plan, can match that of the GLWB product with the additional benefits of flexibility, lower costs and higher potential bequest value for heirs.
Consumer Beware When It Comes to Variable Annuities with Living Benefits
We recently attended the American Institute of Certified Public Accountants (AICPA) Personal Financial Planning (PFS) conference. Jim Shambo, CPA/PFS, is a well noted financial advisor and he provided a number of “really bad items” for this product and we agree with all of them (and discussed a number of them in our two part series):
- High Cost – annuity contracts start with high costs and when the contract values dip below the benefit base, the costs as a percentage of the contract value soar.
- Surrender periods – typically long periods coupled with often high surrender charges.
- Complexity – there is confusion between contract value and benefit base, which misleads many individuals.
- Taxes – annuities are not income tax efficient (as discussed above) and also are not estate tax efficient since there is no “step up” in basis at death.
- Transparency – there is a lack of transparency in contracts, which can be as thick as a book. Costs are never easy to identify or understand.
- Sales process – the sales staff many times does not understand their own product or intentionally avoids telling the whole story about the annuity being sold.
- Living Benefits – the uninformed annuity owner can and often does void the living benefit by taking excess withdrawals.
Annuities, in general, are a tool to assist individuals with meeting their financial goals and objectives. The risk of outliving ones portfolio is real. Therefore, it is important for all individuals to have a financial plan, a set of goals and objectives. Once the goals and objectives are identified, an investment, asset allocation and spending plan can be developed. This is hard work and typically requires the use of a professional. In addition to the “number crunching”, money and all that it entails is a very emotional aspect of people’s lives. A good financial advisory firm will address these issues with their clients.
In certain situations, using an annuity for “longevity” insurance can make sense, such as a single premium immediate annuity. However, it has been our experience that in many more situations, the individual has not done the proper financial planning. There is no clear cut set of rules of the use of the words “financial planner or advisor”. This has resulted in confusion with consumers. Buying a financial product (annuity, life insurance, etc.) is not a plan!
The marketing of annuities as the only financial product an individual will need is a problem, coupled with the very complex nature of these insurance contracts. Individuals need to pay very close attention to contract clauses as each product/contract is different and you cannot apply blanket generalizations across annuity products. We have not seen yet, in all our years of experience, an annuity contract that we feel is in the best interest of the buyer. It may be out there but we have yet to come across it.
We hope this two part white paper series has provided much needed information in this area.
River Capital Advisors, L.C.