Money Magazine still doesn’t get annuities
The following is an attempt to draw attention to the major errors Money made when talking about index annuities (and a few points about immediate annuities). Not every error is an explicit violation — oftentimes, a half-truth exists in a phrase as the author broad-brushed an entire industry of products with a single statement.
The moment I saw the cover of the June issue of Money Magazine, I knew the featured story would touch on annuities. The background image was a roll of hundred dollar bills bobbing in the water and wrapped in a red lifeguard floatie with the headline, “Make Your Money Safer … and Still Get a Decent Return.”
I flipped right to page 66 where the cover story began. The authors (Carolyn Bigda and Susie Poppick) focus their attention on three main categories: 1) stocks, 2) funds and 3) income. Throughout the article, a highly decorated baking motif serves as a way to visualize the author’s ideas. Predictably, the stocks portion offered a six-step recipe to pick stocks without getting burned, and concluded with a list of the pro’s low-risk stock picks (BDX, EMR, XOM, GIS, IBM, UTX, WMT).
Somehow, the fund section of the article was even less imaginative, with a three-step guide to picking funds that won’t collapse (BUFGX, FDGRX, FPPTX, HCAIX, SEQUX, RPMGX, YACKX).
Finally, in the income section of the article, my eye was drawn to the words “Index Annuities,” spelled in red under the sub-headline, “These Investments Are Sold As Safe … But Aren’t As Appetizing As You Think.” The headline was decorated with an ominous looking chef knife for added effect. Here is the text that followed:
The Pitch: Earn the returns of stocks with no risk of losing money, thanks to the underlying insurance on your investment. Your money will also grow tax deferred, and you can convert to an annuity later on.
The Reality: These are complex policies that don’t deliver what you might expect. Instead of mirroring a stock market index, the annuity’s returns are capped — recently many policies limited gains to 3.5 percent annually (the specific cap can change). Worse, those returns don’t include dividends, which have historically accounted for the bulk of the market’s long-term returns. Index annuities also incur high costs. And unless you hold for 10 years or more, you’ll have to pay steep surrender charges to sell — as much as 20 percent to start.
In steps one through three of the income portion of the article, the author championed (1) the virtues of municipal bonds over treasuries, (2) the benefits of I-bonds over TIPS and (3) the advantages low-penalty CDs have over short-term bond funds. But part four was the one that again caught my attention: “The Right Kind of Annuity.” According to Money Magazine, “the right kind of annuity” is a fixed immediate annuity (FIA). This annuity is “an exception” to the expensive and hard-to-understand annuities they warned us about. The article goes on to illustrate how a 65-year-old male who annuitizes $100,000 will receive an annual income of $6,950 – roughly 3 percent higher than their recommended safe withdrawal rate of 4 percent. Readers are advised to buy several different policies with different insurers over a period of time to protect against insurance company failures and low interest rates.
Where Money Magazine is wrong
It wasn’t until I started making this list that I realized what I was getting myself into, but the following is an attempt to draw attention to the major errors Money made when talking about index annuities (and a few points about immediate annuities). Not every error is an explicit violation — oftentimes, a half-truth exists in a phrase as the author broad-brushed an entire industry of products with a single statement.
FIAs are exotic (page 68) – Definition of exotic: “Strikingly unusual or strange in effect or appearance; of a uniquely new or experimental nature.”
When we refer to products as exotic, we are essentially saying that they are outside of the typical boundaries of what we consider to be normal. Exotic products are uncommon, not mainstream.
Consider the sales of FIAs last year. As an industry, FIA sales totaled $32.3 billion. For comparison, variable annuity sales totaled $155.5 billion. In 2011, FIA sales were roughly 21 percent of VA sales, and while Money Magazine has no criticism of VAs, they consider a product with one-fifth the sales of the variable products to be exotic. This is the equivalent of the number one automaker by sales in America, Ford, assuming that their competitor, Chrysler, is an exotic brand with products far outside of what is typical, simply because Chrysler’s sales are roughly 21 percent of their own.
FIAs are expensive (page 68) – In my experience with FIAs, I don’t know of any product that has a mandatory fee built into the base contract. Of course, many FIAs have riders that clients can choose to attach to the base contract and pay fees for, but the base contract is an efficiently designed, no-cost chassis by which their owners can experience modest growth without market risk and without any cost.
Compare this to the typical annual expenses on variable annuities: subaccounts, fund expenses and insurance fees average over one full percent. Additional fees come in the form of annual contract fees and, of course, GMWBs. Unfortunately for the millions of Americans already using VAs to fund their retirement, VAs oftentimes offer lower “roll-ups” while in deferral, lower payouts during distribution and higher fees throughout the life of the contract as compared to their fixed indexed counterparts. FIAs need to be converted into an income stream (page 75) – With all the hype over the Neasham case recently, many of us who have been in the industry long enough to remember the oversold two-tier designed annuities have been having scary dreams at night. As the esteemed Sheryl Moore recently wrote, “the surrender charges on this [kind] of annuity lasts forever.”
It is true that this particular annuity design does require the annuitant to convert their annuity into an income stream. But this two-tier design is a dinosaur in today’s FIA marketplace. Many carriers have discontinued two-tier products completely, while those who once sold billions of them per year now have no market share. While these products are effectively collecting dust on the back shelves of annuity carriers’ portfolios, Money assumes the products of old are still the products being sold today.
The FIAs dominating the industry’s sales today have flexible income benefits that can be activated at will, turned off if desired and even cancelled inside an existing contract. All the while, the owner has access to his or her accumulated value up to the penalty free amount. The days when FIA owners were forced to annuitize their contracts to get income are all but gone.
FIAs are complex (page 75) – The inner workings of crediting methods are not for the faint of heart. I’ve been in the “option rooms” of several major FIA carriers where teams of skilled traders dynamically hedge the insurer’s risks by purchasing copious amounts of various options. But what client needs or even wants to know the nuts and bolts of any financial product? We know how little the average client understands their current assets. They aren’t concerned with why the fund managers at Janus are diversifying their assets in emerging markets from Brazil into Costa Rica, and they don’t want to know the details of how XYZ insurance company makes an annual point-to-point on the S&P 500 crediting method perform the way it does. Clients buy concepts from professionals who have their best interests in mind and who do understand the intricacies of what makes FIAs work.
In many ways, a client moving from the daily fluctuations of any market-based investment to an FIA will have a greatly simplified portfolio. The income benefits grow every year in the way they were designed; the accumulated value remains stable and rises predictably on their anniversary date; any fees in the product are charged as described; and losses in the market will never reduce their contract’s value. The bottom line is that every financial vehicle has some degree of complexity to it, but the safety features built into today’s FIAs do far more to simplify their owner’s investments than they do to complicate them.
FIAs don’t deliver what consumers expect (page 75) – A recent study of pre-retirees found that 80 percent of current annuity owners are happy with their purchase because of the safety it provides them. The number of complaints made by FIA owners has decreased for three consecutive years — three years when sales of these products reached record levels. The top five attributes baby boomers say they want in their financial products are all attributes that FIAs will deliver: stable standard of living, guaranteed income for life; guaranteed not to lose value; protection against market downside; low-maintenance; stable and predictable.
In their essence FIAs are contracts made between insurance companies and individuals; they are guarantees of benefits that the insurer will provide. By definition, FIAs deliver exactly what clients should expect: they fulfill the guarantees made in the contract that clients agreed to when they purchased their annuities.
FIAs do not mirror an index’s performance (page 75) – For once, the author got it right. Thankfully, when the S&P 500 lost 41 percent of its value between 2000 to early 2003 and again lost 51 percent between October 2007 and February 2009, FIA owners did not experience a mirror of the index’s performance. However, over 10 years, the S&P has averaged 3.16 percent. And even with a historically low rate environment, in that same period, FIAs have averaged 5.74 percent, according to a recent comprehensive study of FIAs by the Wharton School of Business.
Rates change and crediting methods vary, products differ from one to the next, but the underlying chassis of the FIA allows consumers to benefit from a portion of the market’s growth while protecting them from the market’s declines. While it is true that FIAs will not mirror the market’s growth, conservative growth that is isolated from market loss can outperform a volatile stock market.
It is often said that hindsight is 20-20. If we can learn about the future from a clear look at the past, what does the last 10 years tell our clients about where their money should be for the next 10 years?
FIAs cannot earn more than 3.5 percent (page 75) – Caps and participation rates within FIAs are lower now than they ever have been before. There are two things I want to draw our attention to on this topic:
1) Annual point-to-point cap rates are not representative of the total growth potential of an FIA.
2) Many clients who currently own FIAs bought them when rates were higher than they are today.
Every good financial professional knows the importance of balancing his or her client’s expectations, but for the sake of showing the range of what is possible, FIAs could perform tremendously well despite today’s historically low rates. The second point to consider is that the greater returns received this year inside FIAs will be higher than the new business issue rates that are advertised in the article. So far this year, some of our clients have seen annual caps renewing at 6 percent on their older policies. While new business is experiencing a depressed rate environment, the potential that all FIA owners have going forward is higher than whatever the current annual cap would suggest.
FIAs returns do not include dividends (page 75) – A dividend is a portion of corporate profits that is paid out to shareholders of that company. It is accurate that in the truest sense of the term “dividend,” FIAs do not pay dividends to their owners. However, many FIAs incentivize would-be investors to buy annuities with a bonus. Think of a bonus as an up-front dividend. The truth is, you won’t get a check from your insurance company every year if their business is growing, but it’s important to consider the various ways that clients receive gains inside annuities and realize it’s not just about new business rates.
FIAs incur high costs (page 75) – We already looked at the cost of fees inside FIAs. Although it isn’t stated explicitly, I have to assume that the author was referring to surrender charges when she stated that FIAs incur high costs. The client has 100 percent control over the cost of his or her FIA because surrender charges are never imposed unless the client chooses to access more of his or her money than anticipated.
When an advisor does a good job of placing the right kind of dollars inside an annuity and the client doesn’t need any more access than the contract allows, there are no costs associated with these products. Still other innovative insurance carriers have products available that allow clients to withdraw 100 percent of their annuity without any penalty.
FIAs must be sold to be liquidated and incur a 20 percent charge (page 75) – With very few exceptions, nearly every annuity sold today has at least 10 percent access available every year with no penalty. A client who wanted to exit an annuity could very quickly access a significant amount of his investment over a period of time without experiencing any penalty.
Additionally, the annuities that have a 20 percent surrender charge generally also are products that offered a sizeable bonus up front. Even if a client did surrender a product with a 20 percent surrender charge in the first year of the contract, 10 percent of the penalty would be paid by the bonus the carrier just gave them, and the total net loss would be 10 percent.
Obviously, surrender charges decrease over time, and it’s unlikely that someone who just committed to a long-term annuity would want to surrender in the first 12 months. Over time, the surrender charges become less and less of a concern. One last note is that throughout the article, the author made reference to 10-year products. For fairness sake, the highest penalty inside of the top selling 10-year FIA starts at 10 percent.
Immediate annuities are superior to FIAs for providing income (page 77) – Immediate annuities have been a great way for retirees to generate a sizeable income stream out of their retirement assets. In fact, a client looking to retire tomorrow would be unable to find an FIA that would offer as large of a payment stream as he could get from an immediate annuity. But the focus of this article is not solely on those clients retiring today. What about those who are preparing for retirement at some point in the near future?
The article shows how a man, age 65, could receive $6,950 annually from an immediate annuity with $100,000 of principal. While this is well above the recommended 4 percent withdrawal rule, it is still less than the client would have received if he had invested the same $100,000 and deferred it for 10 years before income. This strategy would have generated him a $10,324 annual income at age 65 (assuming 10 year deferral, 10 percent bonus, 6.5 percent IAV annually compound deferral rate, and 5 percent single payout percentage).
Deferred income annuities are growing in popularity like never before. New carriers are entering the market every day, and income benefits are extremely competitive. There are dozens of high-quality FIAs that can generate outstanding retirement income when given the time to defer. It’s unfair to make a blanket statement that immediate annuities offer more income than deferred annuities.
Immediate annuities usually leave non-annuitized balances to the insurer (page 77) – The author warns that with “most immediate annuities… if you don’t live very long, the money remains with the insurer instead of passing to heirs.”
We could go into a long explanation of period-certain vs. life-only immediate annuities, but the bottom line is that you don’t have to choose between the two. You can elect to have lifetime income and still ensure that your entire annuity amount will be paid to heirs. There are even extensive disclosures in the product paperwork warning about the risk of life-only annuities. Financial professionals working with a good marketing organization should always structure immediate annuities in such a way that non-annuitized payments go directly to the client’s beneficiaries or even continue for the spouse’s lifetime. The assumption that the majority of immediate annuities leave their owners open to this risk betrays the author’s naivety on the subject of annuities as a whole.
There are only a few circumstances in which financial products draw criticism. One is from clients who have had a negative experience with them. The other is from the competition — those who have a vested interest in protecting their own business from the intrusion of competing products. This most recent publication from Money is nothing more than a market-minded, securities-focused criticism of an industry of products that is changing the way Americans plan for and think about retirement. Hopefully, this review of the errors made in regards to FIAs will serve as a resource for anyone who encounters these objections from their clients.
Note: The article referenced in this post is not available in an online format. It was published in June 2012 in Money Magazine and was written by Carolyn Bigda and Susie Poppick. If you would like to procure a copy of the article itself, please feel free to contact me and I will help you get your own copy.