Annuities have been around for almost 2000 years and the public’s understanding of how they work is at an all-time low.
“I Hate Annuities and So Should You” is what one investment firm says in their full page ads from coast to coast. Why do they spend hundreds of thousands of dollars on those ads? The answer is to attract attention because there is so much confusion about how these products work. What they don’t tell you in those ads is that there are good annuities that have a place in your portfolio if used correctly.
As a Registered Investment Advisor (RIA), I have found that when new prospective clients come in they have strong opinions about annuities and a total lack of knowledge on how they work, and I’m not surprised at all.
In 2013 in the US there were over 194 billion dollars of variable annuities sold and about 40 billion sold of fixed annuities. Breaking those numbers down, 83 percent of all annuities sold are variable annuities and 17 percent are fixed annuities.
Of the fixed annuities sold there are “fixed interest annuities”, which earn a stated interest rate per year for 3, 5 or 7 years, and “indexed/hybrid annuities”, which typically earn interest based upon the one-year gains of the S&P 500 index; but more on indexed/hybrid annuities later.
It has been my experience when someone says “I don’t like annuities” or “I heard that annuities are not good” I ask why. Most of the time they can’t answer the question although sometimes I hear “They are bad.” When I drill down to those who actually had an annuity it comes down to losing money in an annuity. I then go on to explain that the only annuity in which you can lose money is a variable annuity and I explain that fixed annuities have guarantees that are backed by the claims paying ability of the issuing insurance company and you can’t lose a penny if held to maturity.
So when I explain that they are most likely talking about a variable annuity, because those are the only annuities where you can lose money, they seem surprised. We’ll it doesn’t surprise me because stock brokers/registered representatives typically offer variable annuities as solutions for growth and income for many years.
Most of the variable annuities that I’ve examined have fees in excess of 4 percent and earn interest based upon how the “sub-accounts” perform. A sub-account is most likely a mutual fund that the insurance company offers. There are many sub-account/mutual fund options to choose from inside most variable annuities. When I’ve tested performance in the sub accounts they have typically underperformed the S&P 500 index by double digits. Double digit under performance, compounding high fees, and market corrections can cause a variable annuity owner to lose a major amount of the annuities cash value.
Also most variable annuity owners I speak with believe that their principal is protected. If you own a variable annuity and think your principal is protected just call the customer service number of your variable annuity company and ask them “Is my account value guaranteed or protected from loss?” If you want to understand the fees charged, ask these questions:
- What is the mortality and expense of M&E fees?
- What are the administration fees?
- What riders do I have and what are those fees?
- Of the sub-accounts that I have, what are the sub-account fees of each holding?
Don’t allow them to give you an average. Once you have them, add them all up. Keep in mind that these fees are charged, whether or not you make money or lose money.
In my opinion this is why most people don’t like annuities. Either they lost money, were mislead about how the annuity worked, or had a friend who had a similar experience.
Variable annuities also offer “guaranteed income riders” which guarantee a person a yearly income for as long as they are alive. Income riders can be very useful for those who want to create a pension like payment. I call these “income account values” or funny money because it’s not an amount you can take out of the account. It is an amount multiplied with a predetermined percent that will determine what your yearly income stream will be. So the only way to get the money is to turn on the income rider.
The second most popular misconception about how variable annuity works is thinking that the income rider account earnings are the same for the cash account value. Let’s say they think they are receiving a 5 percent step up or some type of minimum interest earned. This amount refers to the income account or funny money account value, and the only way to take advantage of it is to turn on the income rider. Again if you have a variable annuity and think your annuity earns a guaranteed interest call your annuities customer service department and ask them. Ask if you can cash out the income account value. You might also ask if your annuities income rider will allow you to take an income based upon the annuity owner’s life or can it provide a dual payout for both of the spouses? Another question you should ask is if the payment doubles with long-term care.
So to summarize, in my opinion variable annuities could have fees in access of 4 percent, your principal is not guaranteed and if the market drops your account value will most likely drop with it. In past experience, looking at peoples variable annuities has shown that most of the variable annuities income riders only offer a single payout for the owner with no doubling of the income amount if confined to a nursing facility for long-term care.
What is a hybrid annuity? Over the last few years a few very creative insurance agents have come up with names for fixed indexed annuities (or equity indexed annuities) in order to make the public believe they had the “magic bullet” annuity. The truth is, to the best of my knowledge, no insurance company offers a “hybrid” annuity. The agent by doing this causes the public to become confused and then prospective buyers search the name only to be directed back to the agent who spends hundreds of thousands of dollars a month advertising on the Internet.
Let’s take a look at how indexed annuities/equity indexed annuities work and how they are different. For this article let’s use fixed indexed annuity or FIA. The biggest benefit of an FIA is you principal is 100 percent guaranteed and protected from market loss compared to a variable annuity where 0 percent of your principal is protected. Please note that the guarantees are backed by the claims paying ability of the insurance company offering the annuity.
I must admit that it can be quite confusing and a little overwhelming for the ordinary person to make sense of the many FIAs that are offered today. All FIAs are not created equal though.
First, how do FIAs earn interest? There are many crediting methods used to earn interest, however, I will talk about the most popular options. The interest crediting methods discussed are available on about 98 percent of all FIAs offered today.
The first option is a one-year point-to-point based upon how the S&P 500 performs. Most FIAs that offer this method, “cap” or limit the amount of interest you can earn. Rates can vary from 3 to 4 percent. So if the S&P 500 index goes up 18 percent you would earn 4 percent.
The second method is month-to-month for the year with a cap on the upside and no cap on the downside. Then take the gains minus the losses in order to come up with the interest you earn
The third option is where the company offers you a fixed interest for the year.
Those are the three most basic crediting methods used currently. Please keep in mind that there are a few variations of the above methods such as two-year point-to-point and five- year point-to-point.
In my opinion, one of the best FIAs available today offers the person the ability to earn up to 80 percent of the upside of the market and 20 percent earns a fixed amount of 1 percent. With the ability to capture up to 80 percent of the market this allows you to exceed those FIAs that are capped at 3 to 4 percent. For example, if the market goes up 20 percent then 80 percent of your money would be uncapped. In my opinion, this is a much better option then being limited to earning only 3 to 4 percent.
I had a client tell me recently, “So what you’re telling me is that I can have 100 percent downside protection and capture 80 percent of the upside of the market. For that protection, I’m only giving up 20 percent of the upside.”
Most FIAs also offer income riders just as the variable annuities do. Income riders used with FIAs can be very comforting in creating a steady stream of income that is guaranteed as long as you live. It will even pay that income if your cash account runs out.
There are even a couple of FIAs that offer a dual payout for both spouses. What this means is that instead of receiving those annual/monthly income checks based upon one of the spouses, it will pay as long as one of the two spouses is still living. Talk about having peace of mind providing for the other spouse in case of death. Finally, there are a couple of FIAs that will double the payout of the annual/monthly payments if one of the spouses becomes confined to a skilled nursing facility and needs long-term care for a combined 5 years/60 months.
In summary, right fixed indexed annuity will complement and protect a portion of a client’s hard-earned retirement money. I personally don’t use variable annuities because of the ability of a few fixed indexed annuities to earn 80 percent of what the market does plus you are able to have downside protection.
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