Annuities – If They Sound Too Good To Be True, They Probably Are

June 20, 2014 | by James Behr Jr & Christopher Paleologus

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Many variable annuities and index annuities promise a guaranteed return with upside stock market potential. You may have heard “You go up when the market goes up but you won’t go down when it goes down.”  What’s the catch?

Let me begin by stating that the comments below refer to annuities sold as investment vehicles rather than immediate annuities, which are used as lifetime distributions. Annuity plans are sold to people to help them “ensure” financial stability throughout their retirement years. However, people often forget insurance should have only one purpose- risk transfer. No insurance product will both increase wealth and protect against risk at the same time. Little do unsuspecting investors know these plans continue to fall more and more in favor of the insurance companies.  Granted, many annuity plan customers know they are charged high fees.  Many people in their 50s and 60s do not want to endure the emotional turmoil that comes with experiencing stock market volatility.  For these people, the psychological alleviation annuity plans are supposed to provide may be worth the high cost; however, annuity plans cost customers more than they think — a lot more.

 

What Are The Tricks Up Their Sleeves?

Variable annuities typically have many moving parts, sometimes referred to as buckets.  Typically, there is the guaranteed bucket and the investments bucket.  Investors believe they are making a great investment because they have the safety of the guaranteed bucket and the potential return from the investment bucket and can then chose the better of the buckets.  The problem is most investors don’t understand the interworking of the buckets, and many of the benefits are simply marketing ploys or smoke and mirrors.  Below is a list of things to be aware of before purchasing a variable or index annuity.

 

Simple Interest

Investors are often promised an attractive guaranteed return on their annuity- this is the guaranteed bucket.  One detail many customers overlook is that the stated interest rate may be simple not compounding.  In layman’s terms, the customer only earns interest on his or her initial investment, not the current benefit base.  A seemingly majestic rate of 8% simple interest falls to 6.02%, 5.77%, and 4.89% interest compounded annually after 10, 15, and 20 years, respectively.  The majority of the remaining financial world operates using compounded interest, meaning they earn interest on interest.  You must compare apples to apples, something many annuity salesmen fail to mention.  Still a 6%, 5% or even 4% return guaranteed sounds reasonable; however, the method in which these earnings are paid out, by making you annuitize your guarantee, reduces the effective rate even more.

 

Delayed Profits

Think of a lottery payout. We all realize the stated lottery jackpot is substantially higher than the lump-sum cash value.  This thinking can be applied to your guaranteed value on an annuity.  In most cases since you cannot access the lump sum cash value, and the true present value is much lower than the stated guaranteed value.  This begs the question- what use are profits if you can’t touch them?  The answer is- they are of no use.  For example, if someone invests $100,000 at the age of 60 and starts withdrawing at 70, he may not receive his initial $100,000 until age 80 (depending on what percent the payments are as a percentage of the benefit base).  One must ask himself, are there better investment options, am I in this investment for the long haul, and how long will I live?  This sounds discouraging, but it’s simply the nature of the business.  For a more in depth illustration please refer to the chart at the bottom of this article.

 

Restricted Preset Portfolios, Averaging and Caps

This is your investment bucket or the bucket that gives you the possibility of higher returns.  This bucket is usually limited to ensure low risk and, in turn, low potential return.  In many cases the potential returns are so limited that they are unlikely beat the guaranteed rate discussed above.  A popular tactic that decreases potential returns is through averaging and capping returns.  A new client recently came with an annuity contract.  She mistakenly believed she would receive S&P500 like returns with no risk, but boy was she disappointed.  She was not getting S&P500 returns like she thought. Instead, she was getting a return based on the S&P500, which is a subtle difference in language but a major difference in return.  In reality this is how her S&P500 return worked.  She had a monthly upside cap. In other words, each month the insurance company would look at the return S&P500 and cap the return monthly at 2.1%. At the end of the year, the insurance company sums the monthly returns. Her anniversary date is April 2nd of each year.  In the period of 04/03/2012 to 04/02/2013, the S&P500, not including dividends, increased 10.66%, but her S&P500 “like” investment was up 0.81%.  (Please refer to chart for a full explanation).  It is precisely tricks such as this or monthly and quarterly averaging that are difficult for most investors to comprehend and are often glossed over when sold.  Another common way to decrease potential returns is though forced diversification.  Wait, but diversification is good right?  Not when the forced diversification overweighs investments with little potential growth, such as with cash and money markets. Typically an investor is given a menu of investments, which are broken down into different groups.  The investor is restricted to a maximum amount in each group. This forced diversification is usually overnighted in cash and highly-rated fixed income. This is great for the insurance company because the investments they are guaranteeing have very little chance of decreasing in value. This is bad for the investor because the portfolio has little chance of substantially increasing in value and keeping up with the market.
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Proportional Withdrawals

Many companies will reduce guarantee or death benefit for withdrawals proportionally to the market value.  Take this extreme value as a guide for understanding.  Let’s say you own an annuity with a market value of $50,000 and a guaranteed value of $100,000.  You decide to withdrawal $5,000.  Your market value will be reduced by $5,000 to $45,000, which makes sense so far, but the insurance company will argue that $5,000 is 10% of your current value and will then reduce your guaranteed value by 10% or $10,000 even though you only withdrew $5,000.

 

Other Costs

Fees such as surrender charges, management fees, and rider charges can be very expensive. Surrender charges, or charges on all the withdrawals during this period, are generally a percentage of the withdrawal amount. Management fees are fixed charges for managing your money. Finally, rider charges, fees associated with covering potential insurance company costs in the case of illness of death, can fluctuate.

 

So Are Annuity Plans Completely Useless?

The biggest concern for investors is that they are “sold” annuities they do not fully understand.  In a substantially declining market, the guarantees may prove beneficial; however, I believe most investors don’t realize what they are giving up in return for that safety.  Many annuity investors believe the potential gains are larger than what they are in reality and believe their guaranteed return will pay out more than it actually will. Generally, buyers are confused about the true benefits of the plan.

 

When is 8% a Poor Investment Return? – When it is Simple Interest and the Owner is Forced to Annuitize.

The following is a real example found at http://www.jasonwenk.com/2012/04/independent-review-of-the-allianz-vision-annuity-with-income-protector-rider/.  If it appears complicated, that is the point.  I believe if most people understood what they were buying, they wouldn’t purchase this investment.  The example is based on a $100,000 initial investment for a woman 69 years of age.  The investment provides an income rider guarantee of 8% per year, and we are assuming that the guarantee of 8% is superior to the variable portion (because of fees and forced diversification, this most likely will be the case).  As exhibited, the 8% guarantee can be misleading because it uses simple interest.  Even more confusing is the fact that in order to collect the 8%, you must annuitize the entire value.  In this example the investor begins annuitization in year six at age 75 using single life.  This calculates to $7,140.93 annually based on a female age 75.  Using that value, the investor does not even receive her initial $100,000 investment until age 89, and at that point her annualized return is actually 0.34% not 8%.  Even if the investor lives to age 99, her annual returns only calculate to 1.95% annually, hardly the 8% the investor expected.

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