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The Real Scoop on Annuities - Part One
by Steve Selengut
Insurance companies have always been big time financial institutions, and they could probably have claimed possession of the largest and safest investment portfolios on the planet. At one time, their role vis-à-vis Wall Street was clearly that of a giant customer for the securities the investment banks brought to market and which the securities firms distributed. Their real estate holdings were religious in size and quality. They were direct lenders to corporations, their owner-policyholders, and to other institutions. They were the Trustees who managed the private employee pension plans of the world.
Insurance companies sold life insurance policies and annuity contracts that contained guaranteed benefits that depended on their ability to invest safely and soundly. They sold investment management services that built upon their legendary reputation as an industry built upon guarantees, trust, and the financial integrity of their investment portfolios. They were not known for the production of unusually high rates of return, but they were one of only three entities allowed to utter the sacred g-word, and the only one that marketed products that protected people from the financial vagaries of life and death. It was a simpler world then, one less prone to the conflicts of interest, scandals, and financial disruptions that exist on the modern Wall Street. Today, it's difficult to distinguish one financial institution from another as they compete for the ever-growing pool of investment dollars. Insurance companies, now publicly owned, have become am integral part of an industry that seems uninterested in protecting anything other than their obscenely paid leaders.
The time-honored distinction of the annuity contract was the guaranteed retirement benefit it provided. The "you will never outlive your income" boast could not be uttered by any other financial entity! The annuity contract itself was never intended to be an investment product, although the disciplined savings of the deferred variety was certainly given well-deserved emphasis. This was the original old age and disability retirement program--- a contributory, but trustee directed, investment account that anyone could have for a few bucks a week. Like bank savings accounts and federal government securities, risk of loss was not a factor, and the guarantee was a benefit well worth the lower than market yield. Over a hundred years, the concept became generic: Annuity = Guarantee--- safe, solid, and virtually risk free. Equities were nowhere to be seen; derivatives had yet to come of age; neither seemed necessary. The guarantee was enough--- it still is, but annuities are best suited to the healthy poor.
Annuities were developed for the protection of the indigent--- people without the assets needed to generate enough income to sustain them in retirement. An annuity is a series of identical payments made over a specific period of time. Any departure from a plain vanilla, one-life, annuity reduces the payout because of additional time, cash back, or life contingencies. In its purist form, a fixed amount is paid to the annuitant until his or her death. Any leftover funds belong to the company, and the company continues to pay those who live longer than predicted by the actuarial tables--- a simple concept, actuarially pure, easy to deal with, and with no surprises (until the government decreed that men are required to live as long as women).
Annuitants would never outlive their income, but absolutely nothing would be passed on to their heirs; a dismal prospect for the kids, but a valuable benefit for the retiree. The annuity was a last resort scenario for those who didn't have the financial resources to support themselves. I don't know about you, but this sure sounds like a great way to fund a Social Security program! The companies make enough money on the plain vanilla variety to pay their salespeople between 8% and 12%. Typically, they lock-up the money for eight to twelve years with large penalties and pocket most of the additional income that their actual investment and expense experience produces--- but for those who can't fund their own retirements, this is entirely acceptable. A mandatory, fixed annuity based Social Security really needs to be considered to replace the counter-productive system in effect today--- there would be no need for the commissions.
Enter the modern day Variable Annuity oxymoron, sold by an industry that has lost touch with its noble roots, if not the realities of the stock market. The sales pitch emphasizes the prospect of gains in the market rather than the safety and security of the contract. Hundreds of insurance-annuity companies have rushed in to sell their Mutual Funds to unsuspecting retirees, in the form of a much-more-speculative-than-meets-the-eye retirement program. In it's zeal to claim its share of the investment dollar, the industry has rationalized away the risk of equity investments. Financial Planning computer models are programmed to include variable annuities in their asset allocations, shifting the retirement income risk to the consumer. And it's such an easy sell because what the customer hears is: a guaranteed retirement income plus stock market appreciation.
Unfortunately, the stock market never has been able to generate guaranteed levels of income, and sometimes fails to move higher just because we think it should. Serious problems occur when mutual funds are packaged with annuity contracts and the critical differences between them are either overlooked or undisclosed, perhaps innocently, perhaps not. The founding fathers of the annuity contract would not be pleased with today's glitzy versions. Let's back up a century and consider some basics. Just who needs an annuity anyway?
Keep in mind that the annuity produces the largest possible commissions for the salesperson and the largest potential penalties for the purchaser. The variable variety adds the commissions from the mutual funds to the package, and uncertainty to the income benefit. Here's how to determine if an annuity makes sense economically. Is it clear that there is no such thing as a guaranteed variable annuity? The key suitability numbers are easy to develop and to analyze.
The most important number in the equation is your personal expense estimate. How much income is needed at retirement? Always estimate conservatively (that means to use numbers higher than you really expect). If you need a calculator, you're making it too difficult. Let's pretend that the number you decide upon is $48,000, or $4,000 per month. Next, subtract the amount of any guaranteed income you expect to receive from all sources, including social security, pensions, etc. Do not include the value of your investments or properties you plan to sell in this calculation. Again, be conservative, keeping your estimate a bit lower than what you actually expect, and make sure you know why investment earnings should not be included. Let's say that this number works out to be $27,000.
That's it. Now all you have to do is to determine if the investment portfolio can safely generate the difference of $21,000 per year in income (dividends and interest only, please). For the purposes of this analysis, the current market value of the portfolio is used, so make sure that you include the value of everything that is marketable. At today's interest rates you could get the job done safely with under $300,000 but not with normal equity mutual funds or any form of Index Fund. It is totally irresponsible (actually, its worse than that) to rely on equities to provide retirement income. BUT, if the numbers are just short, and (a) a "windfall" (inheritance) is anticipated within a few years, or (b) the retiree is in poor health, an annuity is the last thing that should be considered! You should be able to invest the money conservatively, generate adequate income and have an estate left over for the heirs! Remember to satisfy the income need before looking at equities. There are no exceptions!
So here we have a last resort product, designed for the poor, that the industry has chrome plated, spit-polished, and supercharged for marketing to people who should know better than to include equities in an income portfolio. Why? Is it because financial pros really think these products are universally suitable? Is it the commissions? Or is RISK just a board game that they played in college?
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that
Wall Street Does Not Want YOU to Read", and "A Millionaire's
Secret Investment Strategy"