They used to be called equity indexed annuities, as this article still calls them, before the sales people decided to change the generic name. I’ve written about these before in Retirement Watch, and this article is a good read. It might be a bit too negative. These annuities can be good for someone who would invest very conservatively anyway but wants the potential for a little bit higher return. The person also needs to know exactly what he or she is buying to avoid disappointment and feeling misled. You also need to check fees, especially surrender fees. Above all, shop around. There are wide differences between offerings, as this article makes clear. If you aren’t willing to shop around, learn the product details, and compare them. If not, then stay with investments you understand.
But the products are exceptionally complicated, featuring a host of contractual elements and terms that will be unfamiliar to most investors. And even for those who are willing to invest the time to understand what they’re buying, it’s extremely difficult to comparison-shop to make sure a given annuity is a good one. By the time you understand an equity-indexed annuity enough to purchase it, you could practically sell these products yourself.
That complexity and lack of transparency has prompted entities like FINRA, the self-regulatory body for brokers and exchanges, and the National Association of Insurance Commissioners to issue advisories on equity-indexed annuities, explaining the products and urging consumers to do their homework.
Many people are looking for steady, guaranteed income in their retirement years. There are several different vehicles providing guaranteed income. There are many differences between them. Don’t make the mistake most people make. Don’t consider only one vehicle because that’s what your advisor offers. If you’re interested in guaranteed income, consider the several options out there and compare the results under different scenarios. You should look at immediate annuities, variable annuities with guaranteed lifetime withdrawal benefits, fixed index annuities, and longevity insurance coupled with systematic withdrawals or another annuity during the pre-age 85 years.
Here’s an article that does a good job showing how to analyze a choice. It shows how fees and all the restrictions matter. It also shows that despite all the promises and magic some of these products have, you might be better off with something much simpler and less expensive.
A variable annuity lets your client invest in mutual funds and/or exchange traded funds tax-deferred. Not only are the types of investments limited, but your client also is limited as to how much can be invested in stocks.
The guaranteed lifetime withdrawal benefit is a rider the policyholder gets upon buying this tax-deferred annuity. However, average annual expenses for these types of annuities run greater than three percent—more than your client can earn on a bank CD today. Depending on your client’s age, he or she can get as much as five percent or so annual income from the investment for life–no matter how the underlying investment performs. For example, a $100,000 investment might pay your client $5,000 a year from systematic withdrawals. Once the value of the investment hits zero, the insurance kicks in to continue those payments.
Many people are seeking safe investments and only safe investments. That’s understandable given the events since 2000 and how unprepared many people were for them. The interest in safe money certainly is helping annuity salespeople.
Here’s an alternative view. Keep in mind that I regularly advise people use annuities in their retirement portfolios. But I don’t recommend only annuities. And I recommend certain types of annuities in certain situations. There’s no one-size-fits-all investment. Beware of the financial professional who is selling a product instead of advice and recommendations. The linked piece gives you the other side of the discussion.
I think the whole idea of using fear-mongering as an annuity sales tactic is reprehensible, which is what I’m guessing this guy is doing. The pitch often goes something like this:
Fed up with the volatility in the stock market? Tired of the guys on Wall Street making all of the money? Invest for peace of mind and protect your principal. Call us.
So what’s wrong with this? Far too often the annuity or insurance product being sold carries high ongoing expenses, onerous surrender fees, and returns that often don’t look all that great when you “peel back the onion” and take a hard look at the underlying product. This pitch is common for Equity Index Annuities, a product that prompted even FINRA to post a warning page on its site.
Berkshire-Hathaway, Buffett’s investment vehicle, recently entered into a deal with the insurer Cigna to reinsure some variable annuity guarantees of Cigna. No doubt this will be viewed as Buffett entering the annuity, especially the variable annuity, market and be used as a sales tool for variable annuities. Don’t fall for that line. There are a lot of things wrong with that view.
This article does a good job of laying out what Buffett really is doing, why he’s likely to make money doing it, and why it has nothing to do with whether or not you should buy an annuity. Buffett’s not buying variable annuities for himself. He’s on the other side of the table, and that should make you skeptical about buying a variable annuity.
Buffett’s a smart guy, so I’m sure that he looked at the actuarial life expectancy of the policies, and factored in what I call “the rider procrastination factor.” This Stanism (Stan The Annuity Man speak) is based on an industry estimation that over 60% of lifetime income riders are never turned on by the policy owner. In other words, the person bought the annuity guarantees for a future lifetime income stream, but never seem to turn that switch on. Typical of Americans to have the lifetime benefit and never access it, and I’m sure that Buffett factored that into his decision to reinsure these Cigna policies.
Hartford Financial wants to get out of the annuity business. It wants out of the variable annuity business so badly that recently it offered to buy out the interests of current variable annuity holders. This is part of a trend among insurers to limit or withdraw from their annuity businesses.
The problem for insurers is that to stimulate sales during the boom they offered annuities with very attractive features that never contemplated the potential for an environment like that we’ve had. They protected annuity holders against losses to some extent and in some cases guaranteed minimum returns. Policy owners could take maximum risk in their portfolio choices. The policyholders would benefit if the bull market continued, and the insurers would pay if the investments performed poorly. Other moves insurers are making are to limit the number of investment offerings and require annuity holders to have a minimum level of diversification. The days of using variable annuities to seek maximum returns with limited downside risk are ending. The restrictions make variable annuities less attractive, because it is harder to offset their higher costs and the ordinary income taxes that must be paid on distributions.
Insurers are scaling back from variable annuities as low interest rates and stock market declines weigh on their profits. MetLife Inc. (MET), the largest seller of the contracts last year, said Oct. 31 that sales fell by 46 percent in the third quarter as it cut benefits. Axa SA (CS)’s Axa Equitable and Aegon NV’s Transamerica said this year they are offering to pay clients to reduce risks tied to variable-annuity guarantees.
“We are making this offer because high market volatility, declines in the equity markets and the low interest-rate environment make continuing to provide the Lifetime Income Builder II rider costly to us,” Hartford said in a filing yesterday with the U.S. Securities and Exchange Commission. “We would gain a financial benefit because we would no longer incur the cost of maintaining expensive reserves for the guarantees.”
Investors flocked to variable annuities after the 2000 market crash. Insurers had enhanced the policies by offering guaranteed minimum rates of return, promising to make up for market losses, and other attractive terms. In the current environment, insurers are having a hard time keeping those promises. Low interest rates, lousy stock market returns, and other factors make insurers’ coffers less plentiful than they expected.
The response by insurers is to change their variable annuity policies, sometimes retroactively. That’s just what Prudential recently did, suspending the right of some existing policyholders to add to their accounts on the same terms. Insurers usually reserve the right to change policy terms somewhere in the prospectus. They don’t highlight it, of course, and few policyholders closely read the prospectus and know all the terms. So, changes in existing policies can happen, and you should anticipate more of them in the future since the Fed is keeping its zero interest rate policy until at least 2015.
This squeeze has made it harder for annuity providers to sustain the generous guarantees they offered a few years ago. For example, policies that might have offered a 7 percent growth rate would now offer as little as 5 percent, said Robert Luna, CEO of SureVest Capital Management in Phoenix, Arizona. Guaranteed payout rates that might have been as high as 7 percent have shrunk to 4.5 percent or lower.
The affected Prudential Annuity contracts guaranteed a certain growth rate—in some cases, up to 7 percent—in the policyholders’ benefits accounts. Suspending new contributions to that account limits the amount of new money that can grow there.
“The decision to suspend acceptance of additional purchase payments was made as a direct result of the persistent low interest rate environment that has impacted our industry,” a Prudential spokeswoman said in an e-mailed statement.
There’s a lot of discussion about the number of Americans who enter retirement financially prepared. There are surveys of people that give their self-assessments of their financial position. There are studies of data obtained from the IRS or the Federal Reserve. But one study points out that all these views take the wrong approach. They shouldn’t look at the amount of wealth or income people have at the start of retirement. They should look at the resources people have at the end of life.
This interview with a co-author of this study provides some interesting insights. The study concluded that a high percentage of Americans essentially die poor, with $10,000 or less in assets. The problem isn’t that people start with retirement with insufficient assets. The problem is that they aren’t prepared for surprises or don’t have enough of a cushion. They have adequate income and assets for their expected expenses when they retire. But in the last years of retirement there tend to be a number of financial shocks or unexpected expenses, many of them health or medical related. Many people also overlook that their homes will need substantial repairs or renovations during retirement.
While retirement planning generally assumes a steady draw down of assets, the truth is that spending is far more dynamic and variable. When a portfolio and plan aren’t prepared for this variability, finances can suffer. The interview also covers topics such as why people don’t buy annuities when almost all economists agree they should and why the aging of the Baby Boomers won’t cause a stock market meltdown.
Poterba projected that demand for equities in the years 2020 to 2050 would not decline sharply, arguing that age-wealth profiles would decelerate only gradually—in contrast to the robust surge in asset values on the way up, as the age and wealth of the baby boomers swelled in the 1980s and ’90s.
Market developments since the publication of his research has not altered in any way Poterba’s conclusions.
“I think it is very important not to take a narrow national perspective on this. We live in a global capital market. If there’s an aging population in Japan, they may be able to invest in assets supplied in other countries,” Poterba says.
Economists developed what many call the Annuity Puzzle. To most economists, whether or not to convert a nest egg into an annuity is a no-brainer. They believe a big chunk of your nest egg needs to be in a guaranteed income source such as an annuity. Yet, a small percentage of retirees convert their funds into annuities. Here’s an interesting blog post on the issue by an economist. He starts with a recent New York Times article on the topic and proceeds to point out the errors and omissions in the article.
It’s a good post to read, because most people aren’t going to see this type of analysis. They’re going to meet either with an annuity salesman who’s biased in favor of annuities because of the commission or a money manager/financial planner who’s biased against annuities because they won’t count as part of his assets under management. The points that most people overlook are that an annuity is insurance. It’s insurance against living too long, which half of a given age group will do. It’s also insurance against making mistakes. The insurance company is responsible for investing the money and absorbing the mistakes. Unfortunately, too many people focus on the control issue. They want control over their money, even if they don’t do well with it.
But there are some serious problems with his discussion. One is the way he discusses control as a good thing. Reams of empirical research have shown that, for the typical individual investor, control is a bad thing. Here’s just one fact: from 1991 through 2010, investors in stock mutual funds earned an annual return of 3.8 percent, while the S&P 500 earned an annual return of 9.1 percent. That’s because investors tend to buy high and sell low (based on past performance), and because they generate transaction fees through excessive trading.
This is a case where individuals are better off tying themselves to the mast, like Odysseus before the Sirens, and making it impossible for themselves to make dumb mistakes. Unfortunately, human beings suffer from optimism bias, so most people think they can do better than the market.
An immediate annuity is a good part of many retirement plans. It provides guaranteed income for life, ensuring you won’t outlive all your money and will have a minimum income, in addition to Social Security. Some economists discuss a new reason to buy annuities. They call it dementia insurance. Everyone, as he or she ages, has a reduction in cognitive or decisionmaking ability. That has an impact on a number of things but especially financial decisions. Putting part of your nest egg into an immediate annuity prevents you from making financial mistakes with the money. The economists say that’s one more good reason to add annuities to your plans.
One answer to the challenge of needing to manage money, on the one hand, and declining cognition, on the other, is to purchase an annuity early in retirement. An annuity transforms 401(k) balances into a stream of lifetime income, which requires further decisions. As discussed last week, the cheapest way to purchase the best annuity is to delay claiming Social Security benefits. For those with modest 401(k) balances, the ideal strategy may be to work as long as possible, then use 401(k) assets to pay for living expenses to delay claiming an extra two or three years. The thing to remember is that the monthly Social Security benefit at age 70 is 75 percent higher than that at age 62. And the Social Security annuity is indexed for inflation, a product hard to find in the private market.
The Fed’s zero interest rate policy and some other factors have been hard on insurers, especially those who sell annuities. They can’t promise the guaranteed income they used to when short-term interest rates are near zero and long-term rates are less than 4%. As a result, a number of firms have exited the business or curtailed the annuities they sell.
The latest change is Hartford Financial is exiting the annuity business, looking to sell its life insurance business, and focusing on property and casualty insurance.
The problems for insurers are a significant quandary for those in or approaching retirement. Economists and many financial planners encourage people to buy annuities with at least a portion of their retirement funds. I’ve been a big fan of immediate annuities for many in retirement. But by doing that today, you lock in record low yields. The shrinkage of insurers offering annuities makes it more difficult to shop around and find a good payout from a financially-solid insurer. My advice for many people at this point is to target annuities for a portion of your retirement assets but delay the purchase until interest rates are higher and the annuity market is healthier. Invest the amount targeted for annuities in relatively safe assets, such as high-yield corporate bonds, or in a tactical investment strategy that invests with a margin of safety and automatically keeps losses small.