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Utter the word ANNUITY and watch facial expressions. They range from fear to disgust to confusion. But hear me out: Annuities are not your enemy.
Billionaire money manager and financial pitchman Ken Fisher appears as a haunting senior version of Eddie Munster in television ads. He stares with deep eyes ablaze with intensity. The tight camera shot. A dramatic pause, then solemnly he delivers the line:
“I hate annuities. I’d rather go to hell then sell annuities.”
Which means you should, too. The financial professional with a net worth greater than 500,000 households worries little about lifetime income or portfolio principal loss. He doesn’t think you have to, either.
Ken Fisher is a master marketer. There’s no doubt his prowess in pitching his wares, raking in big bucks for his firm. However, what he knows academically about annuities and how they mitigate life expectancy risk can fit into a dollhouse thimble. And that’s fair because he doesn’t need to worry about running out of wealth. You most likely do.
Based on his past comments in print about the financial planning industry, deeming it ‘unnecessary,’ I understand why he isn’t a fan of anything or anyone but himself. You will pay for his overconfidence if you’re close to retirement or in retirement income distribution mode. He considers an annuity an enemy of your wealth, not a formidable addition to a diversified retirement income plan.
Consider holistic financial planning to determine longevity risk before considering annuities. Annuities, especially deferred and immediate income structures, take the stress off a portfolio to generate lifetime income and place that risk with insurance companies. Fixed annuities allow owners to participate in the upside of broad stock market indexes and can be a formidable bond replacement.
Important annuity white paper.
Respected Professor Emeritus of Finance at the Yale School of Management and Chairman, Chief Investment Officer for Zebra Capital Management, LLC Roger G. Ibbotson, PhD, in a comprehensive white paper, outlined how fixed indexed annuities which provide upside market participation and zero downside impact may be attractive alternatives to traditional fixed income like bonds.
In an environment where forecasted stock market returns may be disappointing due to rich valuations, FIAs eliminate downside stock market risk and offer higher returns than traditional asset classes. Bond yields are more attractive than in previous years, at least temporarily. However, accounting for long-term inflation, bonds will not cut it. According to the study, uncapped fixed indexed annuities would have outperformed bonds annually for the past 90 years.
Per Roger Ibbotson:
“Generic FIA using a large cap equity index in simulation has bond-like risk but with returns tied to positive movements in equities, allowing for equity upside participation. For these reasons, an FIA may be an attractive alternative to (long-term government bonds) to consider.”
In financial services, Ibbotson is a god. Brokers and advisors have misrepresented his seminal chart of 100-year stock market returns to consumers for as long as I’ve been in the business. The chart outlines how domestic large and small company stocks compound at 10-12% and beat the heck out of bonds, bills and inflation; financial professionals showcase the lofty past returns and convince customers that without buying and holding stocks for the long term (whatever that is), they’ll succumb to the vagaries of inflation. Please adhere to the chart, and your portfolio will have it made in the shade! (if invested in stocks for 100 years plus).
Investor fantasy vs. reality.
In all fairness to Roger Ibbotson, it’s not his fault that his data and graphics seduce investors into betting their hard-earned wealth on investment fantasy. He’s long been in favor of annuities in retirement portfolios and accumulation portfolios leading up to retirement.
Investor fantasy:
Investor reality:
At RIA, we adjusted our financial planning software in 2021 to help investors understand how they may retire in a headwind for portfolio returns. The current market cycle may not provide the 6-8% annualized return assumptions promised to “buy and hold” investors and the 10-12% promised by financial pros who misrepresent Ibbotson’s work.
Life gets in the way.
Investors, if lucky, have 20 years to save uninterrupted. As labor economist and nationally recognized expert in retirement security, Professor Teresa Ghilarducci shared with me, “Life has a way of getting in the way.” Annuities create the income bridge that saves under-savers from the danger of outliving their retirement cash flows.
In my 32 years in the business, I have not met a Main Street investor who’s achieved the long-term returns displayed in Ibbotson’s chart. The information is correct, but lures investors into “buy & forget” portfolios regardless of valuations and market cycles.
It’s time to tell the real story about annuities and help you understand how they are not your enemy. And in some cases, your greatest allies.
Not every annuity product is ‘the devil.’
Unfortunately, all annuity types share the same sordid reputation. Those who push annuities to collect attractive commissions leave buyers confused (annuities, by nature, are complex) and regretful.
Salespeople tend to attach expensive riders (add-ons) to annuities that consumers may not need. Overall, the process is not a positive experience.
Good-intentioned and knowledgeable financial professionals fall for pervasive horror stories. They do their clients a disservice by ignoring the benefits annuities bring to those highly likely to outlive their retirement savings.
So, let’s get down to the basics.
What is an annuity, anyway?
An annuity is usually paid in installments over the contract owner’s lifetime or that of the owner and a spouse. Annuities are insurance products that guarantee a lifetime income stream. Pensions are annuities, and Social Security is an annuity structure.
A holistic financial plan can incorporate several types of annuities.
Real Investment Advice readers must understand that annuities are not your enemy.
Here are real investment advice lessons for three of the most popular annuity structures:
Variable Annuities: “The Black Sheep.”
Variable annuities are hybrids, a blend of mutual funds and insurance. Guarantees come as death benefits to beneficiaries or payouts for life if annuitized. The insurance company converts the investment into periodic payments over the annuitant’s or the contract owner’s life. Variable annuities can be expensive and generate big commissions for brokers.
Earnings are tax-deferred and taxed as ordinary income upon withdrawal. Investments in variable annuities are best outside tax-sheltered accounts like IRAs, which are already tax-deferred. Investment choices are plentiful. Various riders can be attached. The most common is the GLWB or Guaranteed Lifetime Withdrawal Benefit rider, which guarantees a lifetime income withdrawal percentage on the principal invested or the account value, whichever is greater. Owners barely understand how variable annuities operate. Many don’t realize their contracts contain riders, how much they cost, or what they do. I frequently deal with the frustration people feel.
Variable Annuities: Proceed with caution.
Candidly, I cannot consider a valid reason for consumers to purchase variable annuities. In its purest form, an annuity should provide lifetime income, increase retirement portfolio longevity, and possess zero downside risk to principal. Most investors already have exposure to variable assets such as stocks and bonds through company retirement plans. I see little rationale for mixing financial oil and water through variable annuities that combine insurance and mutual funds. The marriage of these two appears to be nothing more than a mission to generate revenue for the respective industries.
If you own a variable annuity within an IRA, consider liquidating it and transferring to a traditional IRA. Be wary of surrender charges that may occur upon liquidation. However, taxes and withdrawal penalties may apply. It’s best to sit with a fiduciary proficient with annuities to assist with a strategy to unwind from this product.
Under Section 135 of the IRS code, long-term owners of non-qualified (not IRA) variable annuities may consider exchanging some of their cash value tax-free annually to pay the premiums for traditional long-term care policies.
Fixed Annuities. “The Quiet Ones.”
Fixed annuities, or “multi-year guaranteed” annuities, or MYGAs, are essentially CD-like investments insurance companies issue. They pay fixed interest rates over similar periods, often higher than bank certificates of deposit. However, there is no 100% guarantee that the insurance company will not go insolvent before it gets to the reimbursement. Thankfully, life insurance company insolvencies are rare.
The financial strength of insurance companies offering fixed annuities is paramount. A.M. Best is the rating service most cited. Search the rating service website for the insurance company under consideration here. Best issues six secure ratings. Consider exclusively companies rated A (Excellent) to A++ (superior). For ratings of B, B- (Fair), understand thoroughly your state’s coverage limits. Avoid C++ and poorly rated companies altogether.
The National Organization of Life & Health Insurance Guarantee Associations backs fixed annuities. Each state has a level of protection if an insurance company goes into insolvency. For example, the annuity benefit protection in Texas is $250,000 per life.
The predictability of a set payout and limited risk to principal make MYGAs a popular option for retirees seeking competitive fixed interest rates.
Fixed Indexed Annuities – “A Cake & Eat Some Too.”
Fixed indexed annuities get under the skin of one financial superstar asset allocator who dismisses stock market losses as no big deal (markets rebound eventually, correct?). Losses don’t appear to be a big concern for him or his clients.
As the granddaddy of financial radio personalities, the gentleman relishes the calls into his radio show that express concerns about annuities, especially fixed indexed annuities, as he gets another opportunity to proudly remind his national audience – “so, with these products, you don’t get all the market upside!” Believe me, he’s all about the upside because markets only move in one direction from where he sits. From where you sit and what Roger Ibbotson believes, there’s a strong probability ahead for lower returns on traditional asset classes, including long-term bonds.
How fixed indexed annuities operate.
First, they are not products that invest directly in stock markets; they’re insurance vehicles that provide the potential for interest to be credited based on the performance of specific market indexes. Selections within these fixed annuities allow owners to participate in a fixed percentage of the upside of a market index or earn a maximum interest rate based on the percentage change in an index from one anniversary date (effective date of ownership) to the next. A strategy identified as “point-to-point.”
Second, fixed indexed annuities are characterized by a ‘zero floor,’ meaning there’s no market downside risk. Owners may get a goose egg of a return for a year, that’s true. However, there’s no need to make up for market losses.
Enter Mr. Ibbotson.
As stated in the academic research published by Mr. Ibbotson:
“This downside protection is very powerful and attractive to many individuals planning for retirement. In exchange for giving up some upside performance (the 60% participation rate), the insurance company bears the risk of the price index falling below 0%. The floor is one way to mitigate financial market risk, but also gain exposure to potentially higher equity performance than traditional fixed income investments.”
Third, Roger Ibbotson and his team analyzed the performance of fixed index annuities compared to periods of outperformance and underperformance for long-term government bonds. They isolated 15 three-year periods where bonds performed below the median, like above, where the average 3-year annualized return was 1.87% compared to the FIA average of 4.42%. Through fifteen 3-year timeframes where bonds performed above median, returns for bonds and fixed index annuities averaged 9% and 7.55%, respectively.
Last, the research is limited to a simulation of the net performance of a fixed index annuity tied to a large-cap equity index with uncapped participation rates. A participation index rate strategy is mostly effective under strong stock market conditions, as interest credited is a predetermined percentage multiplied by the annual increase in a market index’s return. For example, a fixed indexed annuity offers an uncapped point-to-point option with a 40% participation rate. If the participation rate increases 10% in the chosen market index, your return for the year will be 4%. The participation percentage may be changed annually.
What is a point-to-point cap index strategy?
When stocks are strong performers, a point-to-point cap index strategy incorporates an upside ceiling and will not perform as well. The point-to-point cap index choice is best when markets provide limited growth potential and 100% participation up to the annual cap set by the insurance company. Let’s say a fixed indexed annuity has a 3% index cap rate and connects to the performance of the S&P 500. For the year, the S&P 500 returns 2%. The interest credited to your account would be 2% or under the 3% cap. Under the participation index rate strategy outlined above, interest credited would be less at 40% of the S&P return, or .8%.
Since credited interest increases the original investment and downside protection is provided, your money compounds in the true sense of the definition. As we’ve written at Real Investment Advice, compounding works only when there is NO CHANCE of principal loss.
Fixed-indexed annuities offer a fixed interest rate sleeve and stock market participation options. You can select multiple strategies (to equal 100%) and change allocations every year on your anniversary or annuity effective date.
Generally, annuities are immediate or deferred, as well as fixed and variable, as described above. Deferred annuities are designed for saving and interest accumulation over long periods, usually 5-10 years. Immediate and guaranteed income annuities are designed to provide lifetime income and longevity insurance for consumers concerned about outliving their retirement investments.
Below are Real Investment Advice’s guardrails or rules to consider before the purchase of accumulation and income annuities:
1. Annuities tend to get sold, but they are not planned. Annuities are primarily product-sales driven. Most annuity salespeople will not undertake a holistic planning approach before offering an annuity solution. It’s essential to partner with a Certified Financial Planner who is also a fiduciary to complete a financial plan before you commit resources to annuities. A plan determines whether an annuity improves retirement income sustainability and how much investment to commit. If your plan reflects the probability of meeting your retirement goals at 85% or greater, forgo the annuity and create an action plan to bolster savings, reduce debt, or work a year or two longer.
2. Consider fixed indexed annuities as intermediate to long-term bond replacements. Or to improve risk-adjusted portfolio returns during market cycles of extended stock valuations and/or less potential for appreciation in bond prices (like we’re in now). Roger Ibbotson estimated that a 60% stock, 20% traditional bond, 20% fixed indexed annuity allocation returned 8.12% from 1927-2016 when bond returns were below median, compared to a conventional 60/40 portfolio, which returned 7.6%. If future returns for traditional risk assets will be muted due to rich stock valuations and lower capital appreciation for bonds (which we believe is the case), a fixed indexed annuity may replace up to 20% of a total fixed income allocation. An FIA may provide attractive returns compared to stocks and bonds, combined with zero downside risk.
3. Minimize exposure to variable annuities. Meet with a financial professional, preferably a fiduciary, to create and implement a liquidation or transfer plan.
4. Understand surrender charges, costs, tax and withdrawal penalty implications. Annuities must be considered long-term products designed solely to meet retirement goals. Deferred annuities will include a hefty 5-10 year decreasing annual percentage charge to discourage liquidations. Investors can incur ordinary income taxes and possibly penalties (if younger than 59 ½) upon withdrawals. Be sure to take into account the charges, commissions, and the cost of insurance as well. Most annuities permit up to 10% annual withdrawals free of surrender charges. Understanding how to withdraw as a last resort is vital if a financial emergency arises.
Riders can be your friend or enemy. Choose wisely.
5. Slow your riders. Riders are supplementary features and benefits that can add anywhere from .35 to 1.50% additional costs per year. Available riders range from enhanced liquidity benefits (ELBs) which allow surrender-charge free return of premiums in the second year, ADL (activities of daily living such as bathing & dressing), or custodial care withdrawals that provide access to up to 100% of accumulation value without surrender charges, to the most popular – GLWBs or Guaranteed Living Withdrawal Benefits for one life or you and a spouse. Lifetime income is guaranteed even if the annuity’s accumulation value falls to zero. I have yet to encounter an annuity owner who can explain why they purchase riders or how they’re supposed to work. Unless a comprehensive financial plan indicates a 25% or greater probability of outliving your retirement savings (75% success rate), and expected single or joint life expectancies are age 95 or older, paying 1-1.5% a year for a living withdrawal benefits rider seems excessive. If outliving your investment source of retirement income is a concern, deferred and immediate income annuities on the market can fill the gap, along with other solutions like reverse mortgages.
6. Seek a second opinion. An annuity is a long-term financial commitment. Before purchase, due diligence is mandatory. A fiduciary professional can outline the pros and cons of your prospective purchase. A deliberate, well-researched decision will minimize regret later. Contact us for objective guidance.
See? An annuity is not your enemy.
Sometimes, it’s the difference between a secure retirement and not.
I hope our guardrails help you gain perspective.
Annuity means ‘check for life,’ and who is against that?
The billionaire Ken Fisher. That’s who. He believes annuities are your enemy.
You need to think differently. For many retirees, annuities are their best friends.