The Lowdown on Annuities: A Basic Understanding
The discussions we as advisors have surrounding annuities can be some of the more frustrating we have with our clients. For some reason these products have become a polarizing topic amongst “industry professionals” and financial reporters. We understand, they are complicated products and the commissions, sometimes north of 7%, the advisors that sell them make is a major sticking point as to whom these products actually benefit. So lets break this down so that you may be able to make a more informed decision about which strategies to employ while formulating your own strategy for tackling retirement.
So what are annuities, really? At the most basic level, annuities are insurance policies. Not that much different than say the insurance your carry on your home or even your life insurance policy. They are contracts in which you give an insurance company money (either lump-sum or installments) and the insurance company agrees to pay you a “guaranteed” future dollar amount in either a lump-sum or installments. Much like other insurance policies, annuities can be rather expensive to have. Focusing on variable annuities, as these seem to get the most questions, it is not uncommon for ongoing policy expenses to range between 2% – 3% per year. Why types of annuities are out there?
The simplest of the annuity products are the simple fixed annuity. These products, while not actually CDs, would most closely be associated with CDs. The issuing insurance company agrees to take your premium dollars and pay a simple, fixed interest rate over a certain period of time. These timeframes can be anywhere between 3-7 years. Typically the longer the time period the higher the interest rate. While variations do occur from insurance company to insurance company these largely operate the same across the board.
The next is the Index Annuity. Unlike the fixed annuity, the index annuity is tied to a market index (such as the S&P 500) with a twist. They typically also carry a minimum interest rate, although it is commonly 0% meaning the account value cannot go “negative.” Does this mean you cannot lose money, no. The amount the insurance company will pay you at a later date is determined by how the selected index performs and any “caps” the insurance company may impose. A “performance cap” is how high the insurance company is willing to credit your account in any given year, month or quarter. Take for example a year the S&P 500 returns 30%… your indexed annuity may have a performance cap of say 7% meaning your account will only be credited 7% not 30%. With quiet literally dozens of indexes you could potentially track and hundreds of different company specific riders that you could add to your policy, this products can vary quiet substantially from issuing company to issuing company.
Finally we arrive at the variable annuity. This is the next progression in complexity. Much like the index annuity the amount the insurance company commits to paying you at a future date will depend on a variable. In this case that variable is the underlying performance of investments you decide to put your money in. Often times these underlying investments can get confused with mutual funds because on the surface they appear to operate in the same manner. They are NOT mutual funds. They do invest money in a similar fashion but that is largely where the similarities end. Your account value will fluctuate much like a standard investment account… when your investments do well your account value will increase and conversely when the perform poorly your account value will decrease. This makes predicting your future payment fairly difficult to pin point. As you can imagine, the insurance companies are putting a fair amount of risk in offering these products and as such the differences between variable annuities between different carriers is vast.
So if these products are complicated and expensive why in the world would anyone put their money in them? This is a great questions and one that is fair to ask. In fact you should be asking it prior to purchasing one of these products. The simple answer is because all of these different products must have a level of guarantees built in. These guarantees are backed by the insurance company themselves and what they are guaranteeing could be anything from a minimum annual income to minimum future death benefit. These guarantees are the key.
Why do the guarantees matter? Entering the retirement stage of your life can be a fairly stressful one. We often hear and read about how the number one fear of retirees is that they will run out of money. For years you might have read about how much you need to save in order to retire based off of a “safe withdrawal rate” (if not read our take here). The basic premise is that if you save “X” amount of dollars you should be able to safely draw down those savings to fund your retirement. There are however two big variables. The first variable is how your investments will perform. The second is nobody knows how long your retirement will actually be. Having a certain level of guarantees that are not necessarily dependent on market returns and are not dependent on how long your retirement will be can help alleviate some of those concerns.
So how should an annuity transaction look? Lets take for example a married couple ages 60 and 62 that need monthly income of $7,000 to cover all of their fixed expenses (mortgage, insurance, cars etc.). Their combined social security, which we believe is reasonable to expect during their retirement, is $3500/month. This leaves them with a gap of $3500 per month that they will need to draw down from their retirement savings. The couple has managed to save a total of $500,000 in 401(k) and IRAs, this is the money they will use to cover the $3500 each and every month. This monthly need far exceeds what is commonly called a “safe withdrawal rate” meaning the likelihood of them running out of money at some point during retirement is fairly high. This couple would be an ideal candidate for an annuity purchase in which they (for example only) purchase a policy for $300,000 that the insurance company will guarantee lifetime income of $3500 per month. This couple has now covered their monthly expenses without having to reach a certain investment return nor do they have to worry about money running out.
So what is an example of who wouldn’t typically be a good candidate for an annuity? Lets take the same couple as above but in this case they have managed to save $2 million dollars. They still need to come up with $3500 per month but due to the additional savings this situation would not call for an annuity. The needed monthly income falls well under the “safe withdrawal rate.” Unless there are other considerations this couple would not be an ideal annuity purchase as the extra expense of that product may not be in the client’s best interests.
So if there is a clear benefit to certain clients for purchasing an annuity why are they such a polarizing strategy? This is a tough question to answer as it appears there are multiple motivations to take that stance. The most glaring one is that they are expense and complicated. As we have already discussed this is true. The next is that they can have lengthy surrender periods, meaning there is a penalty to take your money out early. This can be anywhere between 3-10 years. Simply put an annuity is a long term commitment and should remain a part of your retirement savings once purchased. If your goal is not to have a long term or lifetime goal reached by purchasing an annuity then you shouldn’t buy one. The last reason is, in my opinion, somewhat overblown. Commissions. Annuity products have very favorable commission schedules for the advisors and agents that sell them which can cause your advisor or agent to become short sighted in their recommendation for you to purchase one. These commission schedules can range depending on the company, product and structure of compensation but it is not uncommon for short sighted or even younger advisors/agents to take all upfront commissions meaning they are paid once and in full immediately based on the amount of premium you are purchasing the product for. Variable annuities typically offer somewhere around 7% in all upfront commission on the sale of those products. This means a $100,000 annuity purchase could result in a $7,000 commission for the advisor selling the product. That is a big motivation to offer the product to clients.
How can you safeguard yourself when the topic of annuities comes up with your advisor?
1: Make sure an annuity is appropriate for your situation – In a general sense if you ready to retire, check to see how much income your “safe withdrawal rate” would produce. If it is a comfortable amount for you to live off of then there is a good chance you can pass on the purchase.
2: If an annuity does appear to be appropriate- Make sure to get illustrations from multiple companies. Each company has their own niche and finding the right mix of reaching your goals and the company offering the product can require a decent amount of research and product knowledge.
3: Only buy what your need-One of our biggest pet peeves is seeing clients that had previous purchased an annuity in an even, round number. For example a client with a $200,000 annuity. This shows us that there was not a specific end goal in mind buy purchasing the product. What you should be doing is finding your end need and working backwards to find the amount of premium needed to reach that need. While it is certainly possible that this process may end up with a nice round number, it is not likely.
4: Pay attention to the illustration- Illustrations can be a tricky beast. They will most likely have multiple scenarios that they are showing you. Of those possible scenarios one will be very favorable and have almost ideal rates of return. Do not be fooled. If you are in need of an annuity then we believe you should be focusing first on the guaranteed amounts first. If the product performs better than the contract minimums, fantastic, if not then you will still be in a good spot.
5: Ask about compensation- If your advisor is truly doing the right thing by recommending the product than a discussion about how much they are making off that recommendation should also be fair game. I can tell you that it is our firms own stance that we do not take 100% upfront commissions. Instead we put more emphasis on trails which we believe aligns us better with our clients. Our tail income will increase over time if the product performs better.