Annuities

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The Actual, Practical Pros and Cons of Annuities

Fees

The #1 objection you can read about here are fees. Inside every annuity (variable, indexed, fixed) is the concept of a fee. Those fees may seem high, indeed. That, however, is not necessarily relevant. The actual, practical question should be: could you have done this yourself without the the fee? The easy answer is “it depends.” Depends on what?

  • Amount invested. The fact is that if you have $10,000 to invest, you cannot replicate an annuity’s return by yourself. You cannot hire someone to do this for you. In other words, if your funds are limited, then the fee involved is small enough that an annuity is more suitable not less. Now, this is pretty ironic, since all annuity carriers ask about suitability, and may reject an application if it decides (which it has the right to do) to reject an application.
  • Does your advisor know how? The reality is that it is entirely possible to replicate an annuity payout, without the liquidity restrictions involved in annuities (more on this). For example, an indexed annuity will guarantee the return of principal at the end of the accumulation phase (assuming that there are no additional riders attached). In order to accomplish this, a series of actions must occur in order to ensure that the principal balance will be available to be paid to you. Can an advisor do this? Yes, but that presumes that the advisor himself understands what that series of actions is, and whether or not he has the ability to execute those actions. That will vary wildly from advisor to advisor. That advisor would have to possess specific experience in derivatives, and the ability to execute the derivatives (or the proxy for one). To presume that the advisor will simply “watch it” for you, and then match the payout guaranteed by the annuity is you accepting a risk. Here is why the blanket statement that “annuities are bad, the fees are high” is completely over-simplified.

Liquidity

On this, there is very little question. Every annuity has some sort of liquidity restriction. You cannot simply pick up the phone, and say, “I have changed my mind, send me all of my money back.” There are a few annuities that have this feature, but the feature eats into the return enormously, in which case, there is no practical point to the annuity from inception.

The actual, practical question should be: if I had to withdraw more than the free withdrawal limit (which will vary from annuity to annuity), will the penalty be worth it? If the answer is no, then an annuity may not be suitable. That said, the second actual, practical question should be: what is the probability of requiring an early withdrawal that exceeds the early withdrawal limit? If the answer is high, then again, an annuity may not for you. It is very important to think rationally about the word “probability.” For some people who are very risk-averse, the perceived probability may be high, whereas the actual fact may not be as high. And vice versa.

If the liquidity restraint is not a limitation, then you can continue forward….

Investment Options

Inside variable and fixed indexed annuities are many, many, many alternatives. Reality is that it will be VERY interesting to see how the new Department of Labor’s “fiduciary” rule interacts with variable annuities. For fixed indexed annuities, it isn’t clear, because the suitability of the instrument can be addressed by the fact that there is capital protection which cannot be easily replicated via other methods (read the first section on “Fees”). It will be very difficult to prove that an advisor has not done his job if you purchase a fixed index annuity, for this reason. Now, the question will be about the fees inside the annuity itself, but again, it will be very difficult for a party to accuse the advisor or manager of wrongdoing. VERY difficult.

Back to the point. Inside annuities are an enormous array of investment options. Let’s take a look at some.

  • Equity indices. Your deposited funds can be allocated to equity indices. The different carriers have different variations on all of this. The variations will look innocent, they are not to be taken lightly. There is reason for the “fine print.” Examples of the “fine print” include, but are not limited to: participation rate, cap, floor, point-to-point, averaging. The list is long, the number of different indices is also long.
  • Other indices. Your deposited funds can be allocated to fixed-income, commodity, or blended indices. As above, there is no standardization among carriers, each carrier will have a different variation on the names of these indices, and the calculation method of returns for the indices.
  • Fixed interest. Your deposited funds can be allocated to receive a fixed interest rate for a given period. A traditional annuity will have this feature where the allocation is 100%. Generally, this resets on a periodic basis, as determined by the carrier. There is usually a minimum guaranteed rate to this fixed interest portion. It is very important to note that this is different than a bond index which may be one of the allocation options. An allocation to a fixed-income index (or fixed-income bond fund) is NOT the same thing as an allocation to a fixed interest allocation.
  • Re-balancing. It is very likely that you will be able to re-balance your allocations on a periodic basis, as described by the carrier.

Don’t Be Distracted by Marketing

Every annuity’s marketing brochure points out the potential (but not guaranteed) returns over the long run. Every. Marketing material will also point out the security and potential tax deferral features of an annuity, the benefit of compounding over time. Yes, all true (the probability of an advertisement to be factually wrong is almost zero due to regulatory restrictions placed on the carriers). So, what precisely, isn’t being said aloud?

You are mixing up objectives and Investment Options when you purchase an annuity. The point of this article is that you must first clearly understand what your objectives and priorities are. The reason for that is that an annuity can accomplish some of those objectives, but not all, not without giving something up, something that is large. That said, what is described as “large” here may not matter or apply to you at all.

Let’s take an example. Let’s say you allocae 75% to the first option (S&P 500) and 25% to the second (fixed interest, this is watered down for clarity’s sake).

  • S&P 500 return, 60% participation, 4% annual cap.
  • Fixed interest allocation, 2%.

Huh? So the S&P goes up 10%, and you get 4% on this part of the allocation. so 4% x 60% = 2.4%. On the Fixed interest allocation, you get 2% x 25% = .5%. Your total return is then 2.4% + .5% = 2.9%. There are many ways to discuss this, let’s look at some.

  • It doesn’t go down if the market was down 10%. True if this is an indexed annuity, untrue if your annuity is a variable annuity and that 75% was in equity mutual funds.
  • The stability is good, but the upside is very limited. Here is the issue. If the objective was to have equity exposure, then what was the point? It would’ve been more productive to find a higher interest allocation somewhere else, and a smaller amount of exposure into the equity market where the participation rate is higher and there was no cap. That was the point of equities.

In other words, if you do not have your objectives clearly formulated for yourself, then all of the marketing, fees, liquidity and investment objectives in the world will not satisfy you. The marketing material is not wrong but it is written to appeal to a specific set of objectives, and your specific objectives may be different. That doesn’t mean that an annuity isn’t a good idea: it can be a very good idea, as long as you understand your objectives and make sure that the restraints within the annuity do not “cancel out” those objectives.

More on specific language within annuities will follow in other articles.

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