Where three types of annuities fit in a client's portfolio
By Chris Conklin
Insurance Insight Group
Opponents of annuities often criticize annuity salespeople for supposedly claiming that indexed and variable annuities provide stock market returns without stock market risk, which, of course, isn't possible.
Unfortunately, opponents of annuities have made headway with this and other arguments , as most articles about annuities in the general press seem to have a negative slant. Registered investment advisors tell me that they need to keep extra documentation of the alternatives considered when they put IRA money into an annuity in order to later justify that decision to regulators. Even the AARP has gotten into the act, having recruited AARP Volunteer Free Lunch Monitors to attend free seminars given by financial professionals and report their findings back to AARP and, ultimately, regulators.
The post on AARP's Web site recruiting these volunteers gives you a sense of the negative bias:
The Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and state securities regulators, who are members of the North American Securities Administrators Association (NASAA), sent investigators to some of these events. Their findings were deeply disturbing. "Every rock that we turned over seemed to have a bug or a worm crawling out underneath," says former SEC Chairman Christopher Cox. "In each of the sweeps we conducted, we found significant fraud."
Consumers may go to the seminar with the expectation of learning how to grow and protect their investments and retirement savings. During the seminar, however, and in follow-up phone calls or in-home visits, individuals may be pressured to make unsuitable investment decisions without having done their homework.
The fact is, fixed, indexed and variable annuities all have an appropriate and valuable place in a client's portfolio. Let's compare them to three other popular products -- stock mutual funds, bond mutual funds and bank certificates of deposit -- to see where they fit.
One common way to compare investment alternatives is to look at a spectrum of risk and reward, that is, a spectrum of risk and expected return. Financial vehicles that provide substantial protections against risk are able to attract money at relatively low returns, whereas risky financial vehicles must provide much higher potential and expected returns in order to attract money from investors. Thus, we will put all of these alternatives on a risk/return spectrum:
Now, let's look at the six financial vehicles we are considering. We'll travel from left to right on the risk/return spectrum.
Bank certificates of deposit: These are clearly very safe, as the principal is guaranteed first by the issuing bank and second, up to a limit, by the FDIC. The interest rate you will earn is also guaranteed for the duration you select. If you choose to take your money out early, the penalty is typically very modest, equal to only a few months of interest. According to BankRate.com, the average five-year interest rate offered on a bank CD as of 5/29/2009 was 3.10 percent.
Fixed annuities: These are also very safe, as the principal is guaranteed first by the issuing insurance company and second, up to a limit, by state insurance guaranty funds. Fixed annuities are available in a range of surrender charge durations, many with interest rates that are fully guaranteed for the duration selected. Surrender charges are higher than on bank certificates of deposit, thus making them slightly higher risk for the consumer. The average interest rate shown for a five-year CD-style annuity on AnnuityAdvantage.com as of 5/29/2009 was 3.30 percent.
Indexed annuities: These are a type of fixed annuity, and thus they are very safe. The principal is guaranteed first by the issuing insurance company and second, up to a limit, by a state insurance guaranty fund. Where they differ from other fixed annuities is that the interest rate is not guaranteed at as high a level as most fixed annuities, but the interest rate fluctuates from year to year depending upon movement of the referenced market index and the formula applied to that movement. According to IndexAnnuity.org, over the five year period ending 9/30/2008, the average indexed annuity earned an annualized interest rate of 5.57 percent.
Bond mutual funds: These are securities, and that gives you a clue that we are now entering riskier territory. The principal is not guaranteed by anyone, although they invest in government and corporate debt which is guaranteed by the issuing government or corporate entity. Defaults do occasionally occur, which the managing investment company attempts to mitigate through diversification. The return in any one given year can be positive or negative, although with the exception of bond mutual funds that invest primarily in foreign markets or junk bonds, the return tends to stay within a relatively narrow range. The average return of the Lehman Brothers U.S. Aggregate Index over the ten year period ending 12/31/2008 was 5.73 percent.
Variable annuities: These are also securities, and investors get to choose from a selection of subaccounts that are similar to stock, bond and money market mutual funds. As a result, the value of a variable annuity changes every day that the financial markets are open, and the return in any one given year can be substantially positive or negative. The vast majority of variable annuities offer optional features to mitigate the investment risk, and these features are very popular, although they entail a charge against the annuity's account value. One common feature guarantees that you can withdraw your principal, or perhaps a higher value that the annuity achieved sometime after issue, in level payments throughout 15 years -- even if the annuity has lost value. According to Morningstar, the average annual expense on variable annuity subaccounts is 2.44 percent of assets. Thus, if you have all your money in stock subaccounts and you expect those stocks to earn 10 percent annually, the return you will realize after expenses is 7.56 percent.
Stock mutual funds: These funds invest in stocks, that is, ownership shares, of a broad range of corporate entities. Despite the diversification they provide across underlying companies, annual returns can be sharply positive or negative. A common proxy for their returns is the S&P 500 index, which rose 26 percent in 2003 and dropped 38 percent in 2008. According to Morningstar, the average annual expense on stock mutual funds is 1.32 percent of assets. Thus, if you expect the underlying stocks to earn 10 percent annually, the return you will realize after expenses is 8.68 percent.
So, let's fill in our risk/return spectrum from left to right, going from the safest financial vehicle to the riskiest. We see that as we do so, the expected return also increases.
Thus, the fundamental spectrum of risk and expected return is filled in the appropriate places by fixed, indexed, and variable annuities. As long as consumers properly understand where these various annuities fit and make decisions on that basis, we find that annuities are valuable financial products, and consumers are better off that they exist.
Note: For agent use only. Not to be used for consumer solicitation purposes. Chris Conklin is an actuary, not a registered representative or registered investment advisor. Neither Chris Conklin nor Insurance Insight Group provides investment advice or accepts any liability for the use of the information in this article. This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for investment advice. Please consult with a professional specializing in this area regarding the applicability of this information to your situation.
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