Simple, useful ideas have a way of becoming more complicated – and less useful – as the urge to improve them takes hold. Annuities may have succumbed to this tendency, financial advisers warn.
Annuities, which at their most basic are periodic, lifetime payments by insurance companies made in return for lump-sum contributions, originally were a way for retired people to receive regular, guaranteed income without outliving their money. These “single-premium immediate annuities” are probably what laymen think of when someone mentions an annuity.
Then insurers branched out and created annuities with payments or cash values that vary with movements in the financial markets and have smaller guarantees or none at all.
One type, variable annuities, pays income based on the performance of a basket of investment funds and may be structured to provide a minimum payout each year – at a price – until the annuity is redeemed for cash or converted into a single-premium immediate annuity.
A second type, indexed annuities, ties payments to movements of an underlying stock index and promises at worst to return the full amount invested after a certain period, say 10 years.
Variable and indexed annuities accounted for 81 percent of the $688.2 billion of annuities sold in the three years through 2013, compared with 74 percent in the previous seven years, according to LIMRA, a financial services trade group once known as the Life Insurance Marketing and Research Association.
Although financial advisers consider these vehicles suitable for certain investors in certain circumstances, some contend that variable annuities and especially indexed annuities offer most buyers a poor deal – even if they can figure out what the deal entails. These annuities tend to be overly complex, in their view, as well as expensive and hard to understand, and they often are riskier than investors realize.
“I hate variable annuities,” said Scott Hanson, a senior partner at Hanson McClain, a Sacramento, Calif., investment advisory firm. “There are times to use them,” he added, though “as a general rule I think they’re garbage.”
He reserves particular scorn for versions whose contracts feature a rider guaranteeing an annual payout, now typically 4 to 5 percent. It sounds like having your cake and eating it, too – you are sure to get that amount, and perhaps more if the return from the investment portfolio is sufficiently high – but in his view the cake is too expensive.
About 10 years ago, when the insurance industry was eager to attract annuity investors, it cost 50 basis points, or half of one percentage point, a year to get the guaranteed payout, he recalled. Since then pricing has risen, and “the cost of the guarantees has gone up like crazy, to around 200 basis points,” Hanson said.
For Brian Hayes, chief executive of Hayes Advisory Group, a firm based in Kokomo, Ind., it is not just how much a guarantee costs but how little it covers.
Typically the income is guaranteed, but if the value of the investments tied to the annuity decline, the surrender value – how much cash the annuity can be converted into – may go down, too, he pointed out.
“A lot of times clients get confused, especially if they bought riders that they think protect them from a loss,” he said. “In most cases that’s not true. What’s becoming a problem is that people think the rider protects their account balance, but it doesn’t.”
Whatever the shortcomings of variable annuities, Hanson said he disliked indexed annuities even more. Investors may feel protected by a promise to get their money back after 10 years in the stock market, but he points out that the same amount of money will probably be worth less after a decade because of inflation, and in any case the market seldom has a net decline in any 10-year period, especially when dividends are factored in.
It’s extremely rare, therefore, for the guarantee to come into effect, and the cost of providing it tends to be exorbitant, in his opinion, just as with variable annuities. Insurers often extract the fee for the guarantee and other expenses, such as commissions for agents who sell the annuities, by disbursing only a fraction of a stock index’s gain, say 60 percent, or by capping the gain in any year to a fixed percentage.
“An indexed annuity has caps, your money is tied up for 10 years and there’s no guaranteed income,” Hanson said. “They’re ridiculous. A variable annuity is going to be much better for you than an indexed annuity.”
Brian Ashe, a board member of Life Happens, a life insurance industry association, acknowledged the high expense of some annuities, even placing the upper limit on the cost of income guarantees at three percentage points, not two. But he noted that such a guarantee was worth more to some investors than others.
“The protection offered by variable or indexed annuities has helped a lot of people at or near retirement,” he said. “Having something in the portfolio that provides downside protection can be a valuable part of a person’s financial plan.”
Ashe urged investors to view annuities as part of a whole, not as discrete products. Investors or their advisers should determine how much income they need to cover their bills, consider an annuity for that and use different vehicles for growth or other purposes, he suggested.
Even advisers who avoid variable and indexed annuities for most of their clients prefer them for some. Hayes pointed out that the assets in an annuity accumulate tax-deferred, as they do in 401(k)s and other retirement accounts. Contributions to annuities are not tax-deductible, as they are for many pension plans, but there is no limit on the amount that can be used to fund an annuity, so it can be a useful tool for savers playing catch-up.
“They’re a good fit for someone who is trying to grow a lot for retirement and has maxed out on everything else,” he said.
Because of annuities’ inherent complexities, Hayes encouraged anybody interested in one to “get all the details you can and look at several different options.”
Ashe agreed. “Keep an open mind and ask a lot of questions,” he said. “Annuities can be complex financial tools, and you need to have a good understanding of how they operate.”