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Annuities on Steroids |
Pension Memo |
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Baseball players are not the only ones getting juiced up on steroids. Just take a look at what the insurance industry is doing to annuities. The insurance companies are beefing-up their annuity products to meet the expected demand for them in the next decades. If you follow investments and read the financial press, you will be seeing more articles, information, and hype about annuities. The financial services industry – the mutual fund companies, insurance companies, and banks – foresees a huge market for annuities as the baby boomers retire. In anticipation of this exploding market, the annuity providers are working feverishly in secret laboratories to develop new strains of annuity products. These new steroid-enhanced mutants are beginning to hit the market. They are worth looking at. Annuities are big because investors want them. Annuities provide guaranteed income over a lifetime. A retiree's worst fear is outliving his income, and you can't outlive an annuity. Since few boomers (and their surviving spouses) will get lifetime pensions from paternalistic employers as their parents did, the boomers have to provide their own. That's where annuities come in. Social security will provide minimal guaranteed income. Many retirees will supplement that guaranteed income with commercial annuities. Annuities are sold by insurance companies, so you'd expect on overload of information. A Google search for "annuity" produces more than 5 million hits. I am a fan of annuities, but they are bewildering. Many of my clients purchase annuities, but few of those clients really understand them. Many estates we settle include annuities, but the heirs are often confused by payout and tax options. The coming new breed of annuities will add to the confusion. The principal problem with understanding annuities is terminology. You have to cut through the jargon. The word “annuity” is tossed around loosely and incorrectly in many different contexts. On top of that, the insurance industry, now rearranging the DNA of annuities to anticipate every whim of fussy baby boomers, is rolling out new products with endless innovative bells and whistles. Each annuity provider markets its products under its own brand name, so comparison shopping without professional advice is almost impossible. Kids, don't try this at home. In this memo I will sort out the different kinds of “annuities” you will encounter so you can make some sense of this exploding market. Background An annuity is an insurance policy that, in return for a lump sum payment, provides a guaranteed stream of income over a specified number of years or a lifetime. Sometimes annuities are categorized as "qualified" and "non-qualified." In tax jargon, "qualified annuities" mean those paid from qualified retirement plans. "Non-qualified annuities" are those purchased outside qualified plans with the client's after tax money. In this discussion I will deal only with non-qualified annuities. Annuities are sold by for-profit insurance companies, not a federal agency. In our massive free market system, there are thousands of annuity products to choose from. You can categorize annuities using two principal factors. First, when do payments start? Payments can be paid immediately or they can be deferred. Second, how much will the payments be? The amount can be fixed or the amount can be variable. So, there are four combinations: (i) an immediate fixed annuity, (ii) a deferred fixed annuity, (iii) an immediate variable annuity, or (iv) a deferred variable annuity. It's as simple as that. With regard to the payments, an annuity is "fixed" if the insurance company guarantees the amount to be paid. The insurance company bears the investment risk. Since the guaranteed rate is generally low, many investors prefer to take some risk to get a larger "variable" payout. A "variable annuity" offers a choice of mutual fund investments wrapped in an insurance policy. Gains are deferred (because of the insurance policy wrapper) and the payout is determined by how well the investments do. Here Come the Steroids The Wall Street Journal reports that in 2003 only $5.3 billion was invested in immediate annuities, while $46 billion went into variable annuities. Compare that to the $217 billion that was newly invested in mutual funds. In order to increase annuity sales, the insurance companies are turning to steroids to add muscle to the product. The new breed of annuities offers gee-whiz gimmicks and gizmos: inflation protection, very long deferral periods (i.e., thirty years), cost-of-living increases, and guaranteed minimum withdrawal benefits. However, each of these comes at a cost, which is built in to the product. Should you buy an annuity? Let's take a look at the pros and cons. The Case Against Annuities There is a very large school of thought that says annuities are almost never a good choice. Those critics argue that the costs, taxation, inflexibility, and illiquidity are not worth the benefits, and that you'd do better in low cost mutual funds. The biggest rap against annuities, particularly variable annuities, is the overall cost. You have to ferret out those charges with variable annuities. (Determining costs is not a problem with fixed annuities, because the cost is obvious --- you know exactly what you'll receive each month at the outset. Comparison shopping is much easier in the fixed annuity market.) Variable annuities have mortality charges (after all, it is an insurance policy), as well as investment and administrative fees. The total expenses of a variable annuity can easily exceed 2% per year, which is a persistent drag on performance. Another major negative with annuities is taxation. Year to year gains are deferred until payouts begin --- that's the good news. However, the investment gains are always taxed as ordinary income, not capital gains ---that's the bad news. There is no stepped up basis at death, so the client's heirs have to pay ordinary income tax on those gains. Complexity, inflexibility, and illiquidity are other negatives. The consumer has so many choices that he must make a lot of decisions for each policy. Annuities are long-term investments. Incorrect choices made at the time of purchase are expensive to fix, if they can even be fixed at all. The Case for Annuities We agree, then, that annuities stink. Or do we? If annuities are such bad investments, if they cost too much, if they are inflexible and illiquid, and if the income tax on gains is awful, why do so many people buy them? I think for peace of mind. The annuity provides something we see very little of in the investment world --- guaranteed income that cannot be outlived. That kind of security, even in small portions, can fit into most investment plans. People will pay for peace of mind. Sure, a good mutual fund can outperform an annuity. But, when the stock market plummeted in 2000, many investors wished they had bought fixed annuities instead. Sure, ordinary income tax on profits is not the greatest, but when I retire I'll be in a lower tax bracket. And, if I want to make sure that my wife has guaranteed income after I die so that she doesn’t have to worry, an annuity is a nice supplement to social security. Variable annuities often have a death benefit. At death, your beneficiary will receive the greater of the value of the investments in the policy or your initial investment. So, investment losses are not “lost” at death. Mutual funds don’t do that. Annuities are not subject to the minimum distribution rules, so distributions can be deferred until long past age 70-1/2. Furthermore, unlike IRAs, there are no limits on how much can be contributed to an annuity each year. The insurance industry will sell you as much as you want. Conclusion The new breed of steroid enhanced annuities, and the high powered marketing to promote them, are on the way. Before you automatically turn your back on annuities, take a harder look. Annuities have a place in most portfolios. They assure a base of lifetime income that allows the investor to take a more aggressive position with his other investments. Purchasing an annuity requires the same kind of homework and professional advice you would need to buy long-term care insurance. Both kinds of purchases are complex, and you have to get it right the first time. You can start by getting basic information on annuities at the Securities and Exchange Commission website http://www.sec.gov/investor/pubs/varannty.htm#dben |
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© 2008 Eugene Parrs |
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