Annuities: Approach with Caution (Free Dinners Aren’t Free)

Have you ever received a mailer about a “free dinner” at a local restaurant? All you must do to earn your $50 steak and $12 glass of cabernet sauvignon is listen to a “financial advisor” give you a pitch about “strategies to protect your nest-egg,” or “how to ensure a stress-free retirement in these turbulent times.”

If you don’t have time to read any further, we’ll give you the punchline – those free dinners aren’t free.

Most of these dinners are hosted by insurance agents. They rarely refer to themselves as insurance agents, and usually call themselves “financial advisors” or “financial consultants” or something less salesy. Many of them are stockbrokers – ahem, “financial advisors” – that also have an insurance license.

Usually, the guest of honor at the dinner is some form of annuity – usually a Variable Annuity (VA) or a Fixed Index Annuity (FIA). Both products are pitched as “protecting the downside while participating in the upside.” What isn’t clear is how they compare to a traditionally managed, diversified investment portfolio (which, in full disclosure, is how we manage our clients’ assets) and how much that downside protection costs.

Although, as investment managers we are a bit biased, we want to present both sides of the argument, and we also agree that in some cases, annuities might be appropriate as part of your financial assets.

Types of Annuities

There are many different types of annuities, which often confuses clients and leaves openings for misunderstandings that are not realized until years later. There are four major classes of annuities (which are our definitions and not the exact textbook definitions an insurance company or agent would use): 1) Income Annuities, 2) Fixed Annuities, 3) Fixed Indexed Annuities, and 4) Variable Annuities.

1. Income Annuities.  Income annuities are the most basic and pure form of annuity. An income annuity is very simple – you give the insurance company lump sum of money, and it will provide you a payment stream for either the rest of your life or the longer of you and your spouse’s life. You can either start the payments immediately – which is called a Single Premium Immediate Annuity (SPIA) – or start after x number of years have passed, which is called a Deferred Income Annuity (DIA). They are very simple and straightforward, and they can be a useful tool to create a guaranteed income stream when you absolutely, positively can’t make less than $x. However, because they are so generic and simple, insurance companies don’t make a lot of money off of them, which means a lower commission to the agent – so they won’t be sold much at those “free” dinners. The payments are also dependent on interest rates at the time of sale (which are currently very low).
2. Fixed Annuities.  Fixed annuities are also straightforward. You give the insurance company some money, they pay you a fixed payment for a certain time period. Like an income annuity, the payout depends on interest rates, and generally provides you a rate of return similar to that of a corporate bond. Again, it can be useful if you want a low-risk investment for a defined period. Unlike most income annuities, you don’t lose control of your money as long as you hold it to maturity, so it would be comparable to buying a CD or a bond.
3. Fixed Indexed Annuities.  Now we are sticking our toe into the Swamp of Complexity. A Fixed Indexed Annuity (FIA) is at its core a Fixed Annuity. Put your money in, get a return (with a guarantee of principal protection), then take your money out later (or roll into an income annuity). However, the computation of that return is very complicated. First, you are guaranteed (by the insurance company) to at least break even, no matter what the stock market does. In addition, you get the opportunity to get some upside that will occasionally match that of the stock market. The annuity will track a popular stock market index like the S&P 500 (hence “fixed indexed”), and you will earn a portion of that return in positive years, but zero in negative years. However, you are limited by a “participation rate” and a “cap.” One example might be an 80% participation with a 5% cap. In this example, if the S&P 500 (without dividends) increases 5% in a year, you will earn 5% x 80% participation = 4% for that year. If the S&P returns 15%, you earn 5% (the cap). If the S&P drops 30%, you return 0%. We estimate that the long-term return of a typical FIA would average somewhere between investment-grade bonds and stocks.
4. Variable Annuities.  This is the grandaddy of complex products, and historically the most popular (and most abused by unethical insurance agents). VAs are really two products – an investment account (much like portfolios any investment adviser would use) and an optional income guarantee. The investment account consists of stock and bond funds (called “subaccounts”) that are held during pre-retirement years and grow with the market on a tax-deferred basis. Then, when you need the income, you either a) cash it out as you need it, b) roll it into an income annuity, or c) activate a guaranteed income rider if you purchased one. The guaranteed income feature is the biggest part of the sales pitch, as the agent (truthfully) says that you can get paid 4%-6% of a guaranteed income base per year after you activate it, and the income base may also have guaranteed growth rate which could exceed the growth of your VA account value. What is less clear is if the guarantee is worth the cost. Nothing comes for free. Typically, you will pay three layers of fees – 1) the subaccount fee (typically 0.5%-1.5%) for each investment fund; 2) the management fee to the insurance company (typically 1%); and 3) the optional fee for the guaranteed income (typically another 1%). This is on top of the 4%-8% commission paid up front to the agent.

Positives and Negatives of Annuities

(Yes, there are some good parts!) Annuities have existed for literally hundreds of years, so there are certainly some positive aspects – 1) the concept of an annuity is sound; 2) guaranteed lifetime income can be very useful, especially to retirees; and 3) most annuities have some tax benefits. On the negative side of the ledger, 1) the more popular types of annuities are very complex; 2) annuities can be expensive, 3) certain kinds of annuities force you to give up access to your principal; and 4) (maybe the biggest negative in our view) the agents who sell annuities are not fiduciaries and have much weaker standards of client obligation than Registered Investment Advisors (RIAs) or Trust Companies. An unethical agent (or even an honest but ignorant agent) can do a lot of damage to client’s portfolio and the client may never really figure it out until it is too late.

Positive Factors of Annuities

1. The concept of an annuity is sound.  Annuities originated as a product known as a Tontine, which is basically a financial game of Survivor. Members of the Tontine would put their money into a pool which would be invested. Every year, the investment income would be divided equally among the members – the members that were still alive. As each member died, the survivors split the pool of income among a smaller number of people. In this way, the people who died early were “underpaid,” while the Mesuthelahs were “overpaid.” This concept is known as a mortality credit. While Tontines are no longer legal, annuities provide the annuitant with the same mortality credits by using the assets of the people who die early to subsidize the payments to the people who live to 110. To really boil down the benefit, the dead person doesn’t need the money anymore, but her long-lived friend may be worried about outliving their money. It’s a win-win! It’s kind of morbid to think about it, which is why most insurance products are “sold, not bought.” People need a little nudge to think about it, and a $50 New York Strip often does the trick.
2. Guaranteed income can be valuable in retirement.  Most people who attend the free dinners are nearing the end of their careers, and are worried about having enough money to live out their retirement in relative comfort. It can be very jarring for someone to see their investment portfolio drop by 30% one month after they cash their last paycheck. Plus, losses early in retirement hurt much worse than losses at age 85, because, by selling stocks that are down so much, you can dig a hole that is tough to get out of later. Annuities can help with this risk, by providing a source of guaranteed income that won’t change no matter what the market does. Social Security is an annuity – one of the most valuable annuities in existence, because payments also increase with inflation. Knowing that you will get paid $x for the rest of your life can provide a lot of comfort. Likewise, with a Fixed or Fixed Indexed Annuity, it can be comforting that the value of your investment can never drop below what you put into it, even if the stock market falls 50% and stays down for years.
3. Many annuities have tax benefits.  Most savvy investors do their best to minimize their tax bill, as, unlike market losses, it is money that you have no chance of ever getting back. Most Fixed, Fixed Indexed, and Variable Annuities are tax-deferred products (similar to IRAs), where the account can compound tax free until withdrawal. Also, a portion of many income annuities aren’t taxed (if they are funded with money from a taxable account), since a large part of the money you are getting in that monthly check is simply the insurance company giving your money back to you. We had a client that recently sold an investment property for a large profit. If they were to take the proceeds and put it in an investment account, they would have owed taxes on the entire gain in that year. However, they were able to buy an annuity that would spread the proceeds and the taxes from the property sale over 17 years. We told them to buy the annuity, even though we received no compensation from the insurance company and lost a lot of potential investment fees.

Negative Factors of Annuities

1. Annuities can be very complicated.  The volume of paperwork associated with a Fixed Index or Variable Annuity is breathtaking. The client is presented with a half inch thick document (which, in fairness, spells everything out). As their eyes glaze over, the insurance agent just sort of “hits the important stuff” to move the process along. It is often not clear to the client how much they are paying in fees/commissions, what the key risks are, or a realistic view of future returns. We often look at annuity documents on behalf of clients figure out how they might fit into their overall financial plan, and it is even tough for us – people who do this for a living – to sort out all the terms and conditions and calculations. We believe that the typical annuity client never really knows what they bought other than the selling points.
2. Annuities can get expensive.  In those free dinners, you will hear the word “guarantee” or “protected” a zillion times, but rarely hear what that guarantee costs. Remember that you are buying this from an insurance company, and insurance companies need to make a profit. If you buy car insurance, you pay a premium. Likewise, if you buy an income guarantee, you pay a premium – usually 1% per year, on top of all the other fees you are paying. A Variable Annuity with a Guaranteed Income rider may cost you 3%/year in total fees. If you have a 60/40 stock/bond asset allocation in your sub-accounts, your long-term return gross of fees might only be 5%-6%/year. The fees would cut that in half. Again, you do get a guaranteed income, but it is tough to compare a VA with a rider to an investment account.
3. Annuities are less liquid than traditional investments.  The simplest form of annuity (the income annuity) is not liquid at all. The money you pay up front belongs to the insurance company. You may get all of that back (and much more) if you live a long life (which is why annuities are valuable) but, if you get hit by a bus a year after the annuity starts, that money is gone. Variable Annuities or Fixed Indexed Annuities aren’t as restrictive, but they usually have “surrender periods” of up to 14 years that prohibit large withdrawals of principal without a hefty fee.
4. The incentive structure of the insurance agent creates the potential for abuse.  That’s a strong statement, and there are thousands of honest hardworking insurance agents out there who treat their clients like their own family who would take great umbrage at this, but it’s true. Insurance Agents are not fiduciaries. It’s just a fact. While agents are regulated (and punished in extreme cases of customer abuse) and the SEC’s new “Best Interest” rule provides an improved but still watered-down standard of care for brokers who are also insurance agents, a client of an RIA or Trust Company has a true “advisor,” who is legally obligated to put the client’s needs first. That doesn’t mean that a good insurance agent isn’t putting your needs first, but it does mean that the onus is you to figure out if they are honest or not, or if the product they are selling you is truly the best product for your financial plan. We have heard horror stories of agents who sell a Variable Annuity to a 70 year old woman, collect an 8% commission, then sell her a “better one” three years later for another 8% commission, while she pays a huge surrender fee to roll out of the old one into the new one. The more complicated the product, the higher the commission. A simple income or fixed annuity might only pay the agent 1%-3%, while an FIA or a VA could pay 6%-8%, with another 0.25%-1% per year for 5-10 years. Which product do you think the agent will sell harder?

We have had so many questions from clients about these products that we feel that providing information that shows both the good and bad aspects can help clients who are considering purchasing one. Of course, as “old school” investment managers, we have our own biases, and believe annuities are better used as the “seasoning,” rather than the “meal.” We believe that investing in a portfolio of high-quality, growing companies and managing risk with an appropriate allocation to investment-grade bonds should be at the core of most financial plans. When a client has an overriding need for a guaranteed income stream above and beyond social security and/or a pension, then an annuity may be a good tool to fill in that gap. If you do talk to an agent, make sure to ask these questions:

1. In what ways and how much are you compensated for this product? Is there a more appropriate alternative that pays you a lower commission?
2. What is the total amount of fees that I will pay, up front and per year?
3. (For Fixed Indexed Annuities) are the “market beating returns” compared to the S&P 500 with or without dividends?
4. Walk me through different scenarios with regard to the amount of income I can expect.
5. How long is the surrender period and what are the surrender charges?
6. What is my recourse if I am not satisfied or if I believe I was improperly treated or misled?

At any rate, give us a call or send an email before you sign a contract if you want an independent opinion. Like we mention above, we walked away from an opportunity to collect significant investment fees because the client was better off going with an annuity in that specific case. If you wait until after you buy to ask questions and you aren’t happy, you may be stuck for a while. Even then, we would be happy to evaluate your current annuities in order to a) help refine your financial plan and b) help refine your current asset allocation.

Author ~ Douglas R. Mewhirter, CFA, TCV Trust & Wealth Management, Vice President – Portfolio Manager

Note: Neither the author nor TCV Trust & Wealth Management is licensed to sell insurance products, although we have experience researching and reviewing annuities on behalf of clients and prospects. This article is presented for informational purposes only and is not an offer to buy or sell any insurance product or security.