Annuities, Fixed and Variable
One of the most discounted investments available is the annuity.
An annuity can be thought of as the opposite of a life insurance policy. Instead of creating an lump sum of money, an annuity liquidates one by providing you instead with a stream of income.
The original idea is simple. Suppose you get a lump sum of money, and you have no immediate use for it. What's more, you think you might waste it if it's just sitting in the bank. So you decide to invest it with an insurance company, who will then pay you so much money per month, every month.
The real kicker, or reason for doing this, lies in the options for payoffs. These fall into three basic categories. Period certain, life, and life with period certain.
Period certain means you'll get payments every month for however many years. If you die, your heirs get them. When that number of years is over, so is your payout.
Life payouts equally straightforward. You (or you and your spouse in joint life payouts) get those payments every month until you die. When you die, they stop. You could get hit by a bus the next month, or live another 150 years. However long it is, the payments continue for the full amount of time, and stop as soon as your life is over.
Life with period certain means that the payments will continue for your entire life, however long that is, but there will be a period of some number of years where if you are hit by that bus, your heirs will continue to get payments. This is highly useful to people who have minor children, who are thus assured that their children will continue to get something if they die.
The idea of either of these last two options is that you have an insurance company guaranteeing that you will not outlive the income you get from this money. This can be a very psychologically comforting thing for all sorts of people in all sorts of situations, who are thereby assured that they will have something to live on.
Annuities come in two flavors of beginning, immediate and deferred. Immediate means that here is this lump sum of money, annuitize me (start sending me a monthly check) right now. Deferred means I'm investing it with you, and I may invest more with you later, but let's just let it grow for now as I don't have any immediate need for the money. You can also withdraw money from a deferred annuity without annuitizing, but the tax treatment is not as favorable (see this article)
Annuities also come in two flavors of investment, fixed and variable. Fixed annuities are merged into the general assets and liabilities of the insurance company. You invest with them, they will guarantee you a fixed return, usually somewhere in the range of four to seven percent. Of course they turn around and invest your money and usually earn about 11 percent or so, but they assume the risk. The only risk you have is that the insurance company goes completely bust, but for this reason there are several rating services for insurance companies as to financial strength. One form of fixed annuity, Equity Indexed Annuities, are very popular right now with certain segments of the financial services industry, but any guarantee you can find in any fixed annuity can be found, usually in superior form with a superior product, in variable annuities. However, sales commissions for fixed annuities are much higher, so if you go to the insurance agent on the corner, you're probably going to hear about a fixed annuity, especially if you don't shop around.
In variable annuities, you assume the investment risk while the company still furnishes the insurance component. This is done via investing them in a set of mutual fund-like sub-accounts. Once annuitized, they make use of an assumed rate of return (ARR) on the underlying investment, which is usually between four and six percent. The higher an ARR you choose, the higher your initial payout, but if the results are less than ARR your payments can usually be reduced. Most if not all companies offering variable annuities do offer a minimum payout guarantee, and if your actual rate of return exceeds the ARR, your payments will be increased (indeed, this happens more often than not, within my experience). Variable annuities require not only an insurance license, but a securities license (NASD Series 6 or Series 7) in order to sell them, and are therefore usually purchased from financial advisors. The reason is because now you are assuming investment risk. I will caution the reader that while variable annuity sales commissions are not larger than advisor's mutual funds, there is no reduction for higher investment amounts, so there may be incentive for some advisors to recommend variable annuities when mutual funds might be more appropriate. I have also seen "fee-only" planners take a fee for preparing an investment plan, then a commission for recommending these, where someone working on straight sales charge still gets the commission, but prepares the plan as "part of the package." Nonetheless, when reading articles in the financial press, especially the "self-help" financial press, there is a heavy tendency to exaggerate the downsides of variable annuities, and the hypothesis that best explains the reasoning is that variable annuities require a financial professional to work with you as an individual. If you are working with a professional you trust, you're not nearly as likely to go back to the bookstore or magazine stand for generic drivel with no fiduciary responsibility towards you. Admittedly, some advisors abuse it - and when they are caught, they are prosecuted and the insurance they are required to carry pays. The generic advice in books, newspaper, and magazines never has this responsibility in the first place. They are specifically exempted by the Investment Company Act of 1940.
I read a lot of, well, crap about variable annuity expenses. Most of it in the financial press, which should know better. How they have this expense and that expense and the other expense. The fact is that there are expenses associated with all annuities. The only additional expense that the variable annuity has that the fixed annuity does not is the expense of running the mutual fund-like sub-accounts, which actually average a bit lower than the equivalent mutual fund upon which these are usually based. Every other expense is part of every annuity - indeed, most of them are part of every insurance contract. Administration, Insurance, etcetera. They buy the stuff that makes an annuity an interesting and potentially worthwhile investment - that guarantee that you won't outlive your money, among other possibilities. But because you're dealing with something regulated by the SEC, the agent and the company have to tell you about them in variable annuities, whereas with every other insurance policy, they are a "black box" into which money goes and insurance comes out. Furthermore, variable annuities have a protection that fixed annuities do not. If the insurance company does encounter difficulty (rare for strong insurers), the variable sub-accounts are not assets of the insurance company, and cannot be attached by other creditors. They are yours.
Most companies offering annuities offer several options, depending upon what a prospective client really needs, and in what proportions. When I was in the business, the company whose variable annuities I most often sold when variable annuities were appropriate had twelve different annuities, offering this option or that option, depending upon which fit the clients needs, and they all had the same underlying subaccounts. On the other hand, I was appointed with a multitude of annuity companies, most of which I found had something to offer a certain client that was superior for that client's purposes to other offerings. Furthermore, variable annuity offerings evolve over time. I ran across a reference to one that I used to sell in its II and III editions the other day, and it's now in the VI form due to regulatory changes and a couple of product improvements.
On the pure investment scale, variable annuities have two significant upsides and one significant downside as opposed to mutual funds. The downside is easiest to explain. As previously discussed, they have a so-called "MIE" expense and charge ratio that goes from about one and a quarter to one and two-thirds percent per year (although some designed for asset-based management fees go as low as forty basis points), as opposed to 12-b-1 fees for most mutual funds are about a quarter of a percent per year.
The first upside is the fact that all monies invested in an annuity earn money tax deferred. This means that you're not paying taxes on money invested in annuities as you go, only when you withdraw it. This has the minor downside associated that it's all ordinary income, none of it capital gains, and capital gains may be taxed at a lower rate. Nonetheless, because you're not losing a fraction of your gains, you are earning interest on your taxes for those years until it's time to pay, as opposed to paying taxes on your earnings, after which they are gone. Depending upon various assumptions, this direct trade-off between higher MIE charges and deferred taxes will have a mutual fund theoretically leading an equivalent variable annuity sub-account for about fifteen years (I can get results varying from ten years to twenty-two without unduly torturing the assumptions), after which the variable annuity sub-account (net after taxes and redemption) will take the lead. This does not take into account investment re-balancing, which would work in favor of the variable annuity sub-account, as moving money between those has no tax consequences, something that mutual funds cannot say.
On the other hand, if you're talking about money that is tax-deferred by definition, such as IRA, Roth IRA, and many other sorts, the variable annuity sub-account does not gain the the benefit of the first advantage I just listed, as it is already present. Nonetheless, many very smart people nonetheless have tax deferred money in variable annuity subaccounts. Why? That's the second upside I was going to mention. Because the managers of mutual funds have to sometimes make decisions for the fund based upon tax consequences to shareholders, as opposed to strictly what's the smartest thing to do, investment-wise, as a large proportion of their shareholders investment dollars are not tax-deferred. But every last dollar invested in variable annuity subaccounts is tax deferred. So variable annuity subaccounts will usually outperform the equivalent mutual fund as far as investment return. I've seen estimates that range anywhere from fifty basis points to 150 basis points (0.5% to 1.5%) per year for the average of this number, depending upon who is doing the estimating. Given the 100 to 140 basis point difference in MIE vs. 12-b-1 charges, considered as a pure investment, this aspect of variable annuity subaccounts is likely to fall short of mutual fund returns considered from a strict "how many dollars do you end up with?" standpoint. Note, however, that the MIE buys some guarantees (insurance) in the areas of minimum returns, locking in high investment values, lifetime payouts, etcetera, which mutual fund 12-b-1 fees do not. If you're prepared to undertake a lot more risks, mutual funds will probably (but only probably) come out ahead. If you want some guarantees, the variable annuity sub-account has a lot to be said for it. I know of many people who were looking to retire based upon mutual fund account balances in 1999, who are still down major percentages of what their portfolio value was then. If they had invested in a variable annuity, that 1999 value might have only been 99 percent of the mutual fund value, but they would still have every penny of it and then some.
Caveat Emptor.
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Found an annuity article in the local paper with an error so glaring that I had to debunk it. Here's the article:Income for Life And here's the critical error, conveniently in the first two paragraphs: Interested in annuities? The type... Read More
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