January 5, 2014

3 Logical Insights Into the Notion of ‘Guaranteed’ Annuities

“A lie gets halfway around the world before the truth has a chance to get its pants on.”--Winston Churchill

In my first article in this series, I discussed the logic of index annuities, which most investors – and even many advisors – don't understand. Logically, in my view, if annuity products were more beneficial to clients than an apples-to-apples open market investment, then all insurance companies’ annuity departments would logically go bankrupt because they couldn’t make enough of a spread between actual market returns and the returns that the annuity contracts stipulate.

This month’s topic is a follow-up as I tackle the word “guaranteed.” It seems these days that insurance companies find some way to attach the word “guaranteed” to almost every product, no matter the form, shape or benefit that the product provides. The insurers know that as long as a broker can indirectly use the word “guaranteed” with potential investors in any assumed fashion, products will get sold. So what does logic tell us about the broad analysis of most guaranteed annuities?

Logical Insight #1

An annuity is defined as a legal contract or policy between a consumer and an insurance company. So a guaranteed annuity is when an insurance company promises either a specific interest rate or income for a defined period of time. Even though they can seem very complex, in simple terms, there are only two broad types of annuities – fixed and variable, based on basic security laws. A broker has to have a security license to sell both fixed and variable annuities, but not to only sell fixed annuities. So logically, security laws help us to clearly define annuities as one of two types.

Logical Insight #2

The guaranteed fixed annuity is easily considered one of the safest investments, similar to CDs and U.S. Treasuries. However, I believe there are a number of issues related to generic fixed annuities that many investors (and some advisors) don’t realize, such as:

  • The higher the stated guaranteed interest rate on a fixed annuity, the longer the surrender charge lock-up period 
     
  • A lower stated guaranteed interest rate may or may not result in a shorter surrender period
     
  • High guaranteed interest rates (quoted) in low-interest rate environments, are usually first-year guarantees only (read the fine print)
     
  • Nothing in life is free. Fixed annuities charge fees, in addition to the hidden float spread of the stated interest guaranteed in the contract. Clients need to keep in mind that insurance companies have to make money with their investments over and above stated market yields or they couldn’t stay in business. Investors need to be careful with the stated high interest rate guarantees, because they’re usually limited to one or two years only. 

Logical Insight #3

A guaranteed variable annuity offers assured income for life or for a certain specified period of time. Most are sold as a guaranteed 6% or 7% annuity, with the idea that the investor is guaranteed a 6% or 7% return. Nothing could be further from the truth because, by law, a variable product cannot guarantee return rates and still be deemed a variable security. So the major misunderstandings about guaranteed variable annuities generally are that:

  • The investor gets a guaranteed rate of return. What the investor actually gets is a guaranteed income withdrawal rate, not a guaranteed rate of return. 
     
  • There is no risk in a guaranteed variable annuity. Logic would tell you there is always risk associated with any product in the form of market risk and/or lost opportunity cost risk.
     
  • All an investor contributes and earns in the product is guaranteed for income withdrawal. This also isn’t true, as most insurance companies only guarantee a client’s original contributions. A few will provide guaranteed value upticks, net of their high contract and add-on rider fees, assuming the investor leaves the contract in force for a period of time 
     
  • There are no surrender charges to redeem the variable annuity from their investments. Again, this is false, because any annuity product that offers guaranteed income always locks the investor up for many years, so I urge clients to read the prospectus!  

I believe that annuity guarantees somewhat “bend the truth” when they’re marketed and sold. Have you ever analyzed what I call the “doom and gloom” sales pitch and what logic says would happen? Insurance companies invest their accounts in the same marketplace as everyone else, meaning the guarantees on their products are worthless if Armageddon really happens. 

Logic tells us that for any insurance product created and sold, the insurance company must make money or they wouldn’t create the product. The logical corollary: if a salesman can’t make a good commission from selling the product, it won’t get sold.

So where does that leave the client and the investor? I hope it leaves them assessing these guaranteed annuities logically and with a skeptical eye, because most clients are looking for honesty, integrity and the real truth from an advisor, and not the next silver-bullet sales pitch. .

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