Wednesday, May 16, 2012

Guaranteed Income Annuities: The Holy Grail of Investments?

I recently encountered a client who was anxious to liquidate his diversified IRA portfolio to invest in an annuity that guaranteed a set income throughout retirement. The client had been approached by an annuity salesman who touted an annuity guaranteeing an 8% return and even granting a 5.5% bonus just for investing in the product. Substituting easy to understand investment figures, the annuity salesman had informed the client that he could invest $439,000 today, while he was age 56, and in ten years receive $56,000 every year for the rest of his life.

Doesn’t sound like a bad deal, right? A guaranteed 8% return, $56,000 of income every year for as long as you live, and a 5.5% bonus, or $24,145 (5.5% of $439k) just for investing. These were the benefits of the annuity as the investor understood them. Additionally, the investor understood that the investment came with a surrender period, meaning if he withdrew his investment during the first ten years he would suffer significant penalties – as much as 12%! However, since the investor didn’t intend to withdraw his investments for 10 years, until he was 66 and retired, he didn’t see this as an issue. So, had the investor discovered the holy grail of investments?

After a long struggle with the annuity salesman, I was able to review the details of this product. The investment was a fixed annuity with a rider, or add-on, attached called a guaranteed lifetime withdrawal benefit. The first thing the potential investor was initially unaware of is that this rider came with an additional cost of .95% per year. Yet, it is the rider guaranteeing the 8% return and 5.5% bonus. Without the rider, the return of the annuity would simply fluctuate up and down with fixed-income rates.  The current rate on these products is around 3%.

For investors who purchased the guaranteed lifetime withdrawal benefit, their annuities would have two values going forward. First, the contract value would be the amount of their original investment and would fluctuate up and down with fixed-income rates, as if the rider wasn’t purchased. This value could actually be withdrawn anytime in one lump sum (minus any applicable surrender charges – which again could be up to 12%).

The second value would be known as the income base value.  This is the value to which the 5.5% one-time bonus and 8% annual guarantee would be applied. What was unclear to the investor is that this income base value is an imaginary figure and can never actually be withdrawn. This imaginary figure is simply a value used to calculate annual benefits later down the line. What was also unclear to the investor is that while the income base value does grow by a flat 8% rate during the accumulation stage, the value stops growing once distributions begin. Further, while the investor had heard a lot about the guaranteed rate of return, he was unfamiliar with the withdrawal rate, which is the percentage of the income base value that he can receive in payments each year. In this circumstance, if the investor began taking distributions when he retired at age 66, he would be able to withdraw 5.6% of the income base value every year for the rest of his life. Once the investor passes away, there will be no more annual payments and no residual value.

Clearly, there was more to this annuity than the investor was aware. Given these additional considerations, was it still a good deal? If the client invested $439,000 into the annuity the income base value would provide an additional 5.5% bonus right off the bat, bringing the income base value to $463k. At that point, the income base value would grow by 8% each year until the investor retired in 10 years, making the income base value $1 million dollars when the individual retired at age 66. At this point, the client would begin taking distributions so the income base value would no longer grow. Further, the investor would be paid 5.6% of the income base value, or $56,000, every year for the rest of his life.

This may still sound like a decent deal, but suppose the individual actually had access to the $1 million dollar income base value and simply put the lump sum under his mattress while paying himself the same $56,000 ever year. Even though the million dollars would not be growing at all, the investor could continue to pay himself this annual amount for 17.85 years, or until he was nearly 84 years of age, before running out of money. Unfortunately, the average life expectancy for a 66-year old male is only 16.48 years, or until the age of 82½. Thus, even if the investor lived 1½ years longer than expected, the annual rate of return on the income base value from age 66 to age 84 is guaranteed to be 0%. In other words, the guaranteed income base value guaranteed 10 years of 8% growth followed by 18 years of 0% growth. Over the entire 28 year investment period, the investor would receive an annualized return of approximately 2.98%. Not exactly what the investor had expected. Additionally, after accounting for inflation, the purchasing power of the $56,000 annual payment would decline year-over-year. This would essentially reduce the investor’s income each and every year.

Since payments continue for the life of the investor, the longer the client lives the better the return. However, even if the investor lived to age 100 and received $56,000 every year for 34 years, the implied rate of return during the withdrawal period would be 4.23%, far from the 8% the investor was expecting.

The one benefit of the annuity is that it GUARANTEES a return, and as we just established, that return is around 2.98% assuming the investor has an average life expectancy. For investors who simply can’t handle seeing their investments lose money, this may have a value. However, I would argue a similar or superior return could be generated with a simple fixed annuity with no expensive, hard-to-understand riders attached.

Investors who hate risk but can tolerate a minimal amount of loss in their portfolio on rare occasions might consider a conservative, diversified asset allocation such as a 15% stock, 85% bond portfolio. Over the last 42 years, a diversified portfolio with this asset allocation has had a positive annual return 36 times and a negative return 6 times. Further, the most the portfolio ever declined in one year was (3.34%). However the average annualized return of this portfolio over the 42 year period was 9.46%. Clearly, for an investor who can handle minimal investment declines, this appears to be a far superior strategy when compared to the annuity with a guaranteed benefits rider. Further, the investor’s money is completely liquid with this strategy. Money can be withdrawn in a giant lump sum with no penalties anytime the investor desires. Again, this is never possible with the income base value.

Clearly, annuities are incredibly complex investments. Unfortunately, they are meant to be so. Frequently, annuity salespeople rely on investors not understanding the entirety of the annuity contract to complete a sale. If you’re ever introduced to an annuity or other investment vehicle that sounds too good to be true, be sure to read the fine print in the investment contract. If you need additional help, seek the advice of a fee-only Certified Financial Planner® who acts as a fiduciary. These financial planning professionals are not paid a commission for selling financial products, and are more likely to give you an honest, unbiased opinion of the product you’re considering.


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Darnell King said...

Is it just me, or are all of these advisers that claim to have their clients best interests covered, simply offering all of these annuity packages to make their quota and maintain the bottom line of the company. I had a financial adviser that I thought was my friend. Turned out that he would be pocketing a large amount of my money from the initial payment, and the rest would be locked up for years and years to come! What a sham!

Anonymous said...


I find your assessment of the said annuity to be fairly solid, however, just like all other market driven advisers you neglect to give a thorough risk assessment of your own solutions.

A portfolio of 15% stock and 85% bonds has had AVERAGE returns of over 9% for the past 42 years. That is terribly skewed by the 80 and 90s. Additionally, average returns, are not the same thing as compound.

When you discuss the annuity solution and the client deposits $439,000 with you ten years ago with the goal of having $56,000 per year of income beginning in 10 years, you assume that his investment will be 1 Million in 10 years. Well, this past 10 years that is no where close to the truth. In fact had the client deposited $439,000 he would barely have more than that 10 years later and now begin taking withdrawals of $56,000 per year from a portfolio that is only $500,000. So now that client will be out of money in 8-12 years.

The annuity GUARANTEES them the income no matter what and the market DOES NOT.

There is excellent withdrawal analysis done by Jim Otar, who is an financial engineer and provides an in depth calculator to help consumers make educated decisions about their portfolio when it come to providing income.

The time value of fluctuations is something advisers as your self no nothing about and ignore as if NONE of your clients have been or will ever come up short of their retirement income goals.

Adding annuities to any portfolio will enhance the probability of it's success 100% of the time.

Lon Jefferies said...

Dear Anonymous,

I'm afraid you are mistake about several items. First, the 9.46% average annual return of a 15% stock, 85% bond portfolio mention in the article is an average annualized return (i.e. compound return)...

Second, I'm afraid that return isn't at all skewed by the 80's and 90's, and a $439,000 investment in such a portfolio** 10 years ago would not now be worth $500,000, but rather $994,479. Consequently, yes, these historical return figures are "close to the truth."

No, this conservative 15/85 portfolio did not guarantee the income, however, it still more than accomplished the investors goals and will provide a more enjoyable retirement than the annuity. However, this portfolio DID guarantee that there were no surrender charges, no extra expenses for the riders, and more liquidity. As opposed to the annuity, the portfolio also DID NOT guarantee that there would be a residual value when the investor passes.

**The stock portion of the portfolio consisted of: 25% DJ Wilshire Large Company Growth Index, 25% DJ Wilshire Large Company Value Index, 10% DJ Wilshire Midcap Growth Index, 10% DJ Wilshire Midcap Value Index, 5% DJ Wilshire Small Company Growth Index, 5% DJ Wilshire Small Company Value Index, 20% Morgan Stanley EAFE Index NR USD; while the bond portion of the portfolio consisted of: 40% Lehman Bros. Long-Credit, 40% Lehman Bros. Long-Term Govt. Bond Index, 20% Citigroup Non-$ World Gov. Bond Index;

Thanks for your comment.

Lon Jefferies

Douglas Mortensen said...

Why is it that so many of these "debates" are an all-or-nothing proposition? If (and I don't recall reading it) the client was in great health, and whose family had a history of beyond-average longevity, he is exposed to longevity risk. A PORTION of his portfolio could be be invested in an annuity to protect against the risk. I agree with Lon that a "simple" version, without confusing riders, would probably be wise.

I am little suspect of past performance figures when investing in securities, especially when it was largely built on bonds. Buying fixed-income securities today (I realize article was written in 2013), means buying in to some relatively low yields. It seems a 9% return would be less probable. However, I do like the marketability (not liquidity...I learned the differene early in my career which was confirmed in CFP course.) of the securities portfolio vis-a-vis the annuity option. The small equity portion provides some protection against purchasing power risk.

I think that we could all be doing a better job for people if we balance recommendations against the risks they are exposed to, and which ones that they are most concerned about. Without knowing the client's complete situation, it is difficult to know, but I would be in favor of a 50/50 split (with a plain vanilla annuity) over an all-or-nothing choice.

Just a thought.