As advisors who often talk about annuities to financial advisors, we are often asked whether we like annuities. To that question, our standard answer is that we neither like nor dislike them — because they’re just tools, which work well in certain circumstances and do not work well in others.
That said, there are certain arguments against annuities that frequently circulate, many of which disregard critical information or present an inaccurate summary of a complex issue. Here are five of the arguments we hear most often, and our analysis around each.
1. They’re too expensive.
Perhaps the most common argument heard against deferred annuities is that they are too expensive. Usually, this criticism refers to variable contracts, as most fixed annuities assess no front-end or annually recurring charges. The costs for the insurance offered by the guaranteed living benefits of variable annuities can be, and often are, seen as excessive, and that this judgment may result from the application of investment analysis methodology to an insurance problem. One example of this misapplication appearing frequently in the financial press is the side-by-side comparison of a variable annuity with a mutual fund, assuming the same gross investment return and liquidation of the investment in a lump sum at the end of a specified period. Even where the analyst attempts to be fair and reasonable with income tax assumptions (e.g., taking into account the turnover rate in the mutual fund portfolio and the fact that not all distributions are taxed at long-term capital gains rates), assuming that both alternatives will earn a specific positive rate of return each year renders the death benefit guarantees of the annuity inoperative. Moreover, the stipulation that the investor will cash out both alternatives in a lump sum obviates the advantages of the taxation of annuitized proceeds and assumes that the annuity payout factors guaranteed in the annuity can never be of any value. The costs for these insurance features are taken into account each year by reducing the gross return assumed on the annuity by the mortality and expense charge. The potential benefits purchased by those costs are precluded from ever being realized. Such a comparison may be side-by-side, but it is not truly apples to apples.
An even more egregious example of unfairness occurs when the comparison pits a fully commissionable variable annuity (VA) against a no-load mutual fund. On the VA side of the ledger, the costs include compensation to the financial advisor, including ongoing renewal commissions. These commissions pay — not simply for the advisor selling the annuity — but for the financial counselthat the advisor renders to the investor as part of the sale. This includes the initial asset allocation and ongoing servicing, portfolio rebalancing, etc. On the mutual fund side, there are no commission costs — which necessarily implies that the investor is receiving no financial advice. In the authors’ opinion, such an analysis is no more fair than a comparison of the bill presented to a client by a competent estate planning attorney with the cost of do it yourself legal software such as Quicken WillMaker Plus.® The product in both cases may be a valid legal instrument, but the attorney’s documents were informed by individual professional counseling and the attorney’s client will have recourse for liabilities caused by errors or problems through the attorney’s actions or work.
If the investor does not want or need any counsel, he should not be required to pay for it. But where advice is both wanted and needed — where it has clear value — both the benefit of that advice and its cost should be reflected on both sides of the comparison. Thus, if the mutual fund considered, hypothetically, of course, is a no-load product, and where the annuity cost includes compensation to the investment advisor, fairness would require that the mutual fund side of the ledger include a separate cost for advice. That sort of comparison is rarely seen.
With regard to the notion that variable annuities are too expensive, it should be noted that a few insurers have recently released contracts with verylow annual expenses. Some of these contracts offer guaranteed living benefit riders, yet their annual expense ratio is less than the typical VA.
2. They’re too complicated.
The values guaranteed by living benefit provisions in variable annuities are often the result of formulas and conditions. Rarely can one point to a dollar figure and say “this is the amount guaranteed by this benefit.” Perhaps most painfully, the terms under which the guaranteed amounts themselves are payable can be quite complicated. The result is a serious potential for misunderstanding and confusion, both by those purchasing these contracts and by those selling them.
For example, a Guaranteed Minimum Income Benefit (GMIB) provision may apply a guaranteed interest rate of 6% to amounts invested, to produce a benefit base from which GMIB payments will be calculated. This does not mean that the contract owner is guaranteed a minimum of a 6% return on his investment, as would be the case if the guaranteed cash value of the contract could never be less than contributions compounded at 6%. Yet the authors have heard this provision explained in just that way on several occasions — not only by policy owners, but also by professional advisors. Clearly, these individuals had no idea how the GMIB provision they were describing actually worked. Jack Marrion, in a recent study of Guaranteed Living Benefits, writes that he has received many emails from VA purchasers who state that “they were receiving, or were told they would receive, a guaranteed 7% a year payout for 14 years and then they would still get at least 100% of their money back at that time,” despite the fact that the GMWB guarantees only that 7% payment for 14 years.
In the authors’ view, this is potentially a very serious problem, for both advisors and their clients. Any competent decision as to whether a guaranteed living benefit is worth, to a particular client, what the insurer charges for it necessarily requires that all parties to that decision fully understand what they are assessing. Some insurers, recognizing this, have instituted special training programs to ensure that those recommending these complex products understand them. The NAIC has also recognized this problem, and included, in its Suitability in Annuity Transactions Model Regulation of 2010 (SATMR), a mandate that agents recommending any annuity complete a four-hour continuing education course specifically devoted to annuities (see discussion of SATMR in Chapter 14). In the authors’ experience, far too many agents selling annuities do not thoroughly understand the complexities of the annuity contracts they are selling, and the SATMR-required training is long overdue. Some, but certainly not all, agents know about the products they offer only by what they read in point-of-sale brochures and hear from product wholesalers. Far too many have never read the annuity contracts.
Similarly, many advisors fail to understand the complexity underlying at least some types of equity-indexed annuity contracts. Although some use formulas that are relatively straightforward and easy to understand, others do not. A failure to understand the implications of crediting formulas in allpotential return environments — not simply the one illustrated in the marketing materials, which is often not merely an average scenario, but an optimal one — can lead to a mismatch between client expectations and reality.
The authors strenuously recommend a serious study, both of the marketing brochures and the actual contract language describing policy provisions — especially, the descriptions of guaranteed living benefits for variable annuities and the crediting formulas for equity-indexed annuities — to anyone who intends to provide recommendations regarding annuities with such provisions. We also recommend that any advisor who intends to sell, or offer advice concerning these benefits take advantage of special training classes on the subject, even if these classes are not yet mandated in the states in which they work.
Guaranteed living benefit riders, and equity-indexed annuities, when properly understood, can be of significant value to many clients, but both advisor and client must be capable of wading through the complexity to know what the annuities will, and will not do. It’s not impossible to understand the sometimes complex provisions contained in annuity contracts. Although, arguably, there are a few exceptions where the contracts are so complex only that the actuaries who designed them may ever fully comprehend how they work! If an advisor and their client are not willing to get a handle on the complexity involved, it may be better to select an alternative route.
3. Annuities should never be used to fund an IRA or qualified plan.
A generalization often made about annuities claims that they should never be used to fund an IRA or qualified plan. This sweeping pronouncement has met with surprisingly wide acceptance among financial journalists, attorneys, accountants, and many financial planners. It has become virtually accepted wisdom for many, despite the facts that: (a) it ignores the huge differences that exist between immediate and deferred annuities and between the fixed and variable varieties of the latter; and (b) the arguments most commonly made in its support are grievously and obviously flawed.
Those who argue that annuities are inappropriate instruments for funding IRAs or qualified plans are almost always referring to deferred annuities, and, usually, to variable deferred annuities. The three most common of these arguments are:
1. “You’re paying for tax deferral you’re not getting.” This is simply nonsense. While it is true that an annuity offers no additional tax advantages over any other investment vehicle when used to fund an IRA or qualified, no annuity assesses any charge for the benefit of tax deferral. To be sure, variable deferred annuities impose charges that alternatives such as mutual funds do not. Those are, as we have seen, insurance charges. They have absolutely nothing whatsoever to do with the tax treatment enjoyed by the annuity. The tax treatment of an annuity used to fund an IRA or qualified plan is identical to that applicable to any other IRA investment. The treatment which would apply to a deferred annuity, if it were not used to fund such a plan, is irrelevant when the annuity is so used.
The insurance charges of a variable deferred annuity may or may not be worthwhile to a particular investor, based upon that investor’s need for the risk management benefits the charges pay for; but this is true whether the annuity is funding an IRA or is a nonqualified annuity. If the insurance benefits are not worth the cost to a particular client, then they should not be paid for, whether the money in question is qualified or not.