Based on client concerns over market volatility over the last couple market cycles, I once again investigated immediate annuities as an alternative investment strategy for a portion of some retired clients’ portfolios. For full disclosure, as a fee-only planner I have never recommended an annuity to a client—other than rolling an existing annuity into a better choice—as we always felt there were alternatives that were a better deal for them. For background, annuities are sold by insurance companies and are designed to give a stream of income for the balance of one or both of a couples lives.
An immediate annuity can be either a fixed annuity or variable annuity.
Fixed annuities-These annuities are funded with an initial lump sum typically $10,000 or more and for this initial investment the insurance company will pay a set amount every month for the rest of one or both of a client couples lives depending on the type of annuity they buy. The amount they will guarantee is based on age, where they live and their life expectancy. To protect against a premature death guaranteed payout from 5 to 30 years can be purchased, but the amount of the monthly payment will be reduced for this guarantee. This protects the clients’ heirs if they buy an annuity then get hit by a bus the next day because the insurance company no longer has any obligation to make any payments from your initial investment without this guarantee period
Variable annuities- These annuities are also funded with an initial cash investment but they have underlying investments which, like mutual funds, allow a contract owner to take advantage of potential growth opportunities. However, these do involve market risk and could lead to losses if the value of the underlying investments falls. Variable annuities are usually appropriate for those with longer time horizons and thus better able to handle the market’s fluctuations. The variable annuity I researched had a guarantee withdrawal benefit amount (GWB amount) of a 5% withdrawal every year as long both of the clients live. But the client pays a high fee for this insurance. The annual expenses were .85% fund expenses, 2.05% annuity charges and an additional 2% withdrawal charge if you take more than the 5% allowable annual withdrawal rate in the first five years. These fees were fairly typical. This means for the value of the annuity to grow assuming they take 5% out each year the underlying investments would have to grow at something like 7.9% to cover the annual expense and their withdrawal. Nice returns if you can get them.
The advantages of annuities are:
- Regular streams of payments for the rest of your lives -but the monthly cash flows are typically low.
- It mitigates longevity risk-the chance of clients outliving their assets- both fixed and variable with the guarantee income withdrawal benefit accomplishes this.
- The money put into the fixed annuity will no longer be subject to market fluctuations as clients experienced 2008-2009 and the last quarter.
The disadvantages include:
- The costs for annuities are high.
- Because of the high cost the investment returns are not great and depending on how long the clients live can very unattractive.
- The fixed annuity has no upside if markets are going well and with the variable annuity the first 3% of market gains each year are taken by fees.
- Liquidity risk- client no longer have access to the initial funds they put into the fixed annuity if they need the money for large expenditures, if interest rates go up or they change their mind.
- No money left for their heirs when they both die with the fixed annuity or if the variable annuity is drained by withdrawals.
- There is solvency risk if the insurance company has financial problems (Think AIG which was a popular seller of annuities -AIG did not go bankrupt but they had to be bailed out).
- The payments are taxed at ordinary income rates vs. capital gains or qualified dividend rates on other investments. The client therefore might want to use IRA funds for these since withdrawals are going to be taxed at ordinary income rates anyway.
Examples of three types of annuities I investigated included:
- A fixed annuity
- A fixed annuity with a cost of living adjustment tied to the CPI
- A variable annuity with an underlying investment of 60% Stocks 35% fixed Income and 5% cash and Guarantee Income Withdrawal Benefit amount (GWB amount) of 5%
For all the annuities I used the following criteria:
- Initial Investment of $100,000
- Joint Life- They will continue to pay as long as one of the couple is still living
- Husband is 67 and wife is age 65 and they live in California
- The fixed annuities will be paid for 10 years
- Payments will begin immediately
|Annuity||Fixed||Fixed with CPI Rider||Variable with GWB|
|Minimum Total Payout||$57,375||$36,920 inflation adjusted||Depends on how long they live|
|Minimum Payment to if one of the couple lives 20 years||$114,751||$73,840 inflation adjusted||$100,000|
|Cash value when at death or want to cash out annuity||$0||$0||Depends on how the investments have done and when you decide to cash out|
The fixed annuity is guaranteeing a 5.7% withdrawal rate but as inflation goes up the clients’ buying power will be eroded each year.
The fixed annuity with the CPI rider gives you a 3.7% withdrawal rate but will keep up with inflation.
The variable annuity at least has some upside but statistically there is less than a 10% chance the client will ever take advantage of the GWB amount, so this is giving up quite a bit of upside for the remote possibility of protecting the guaranteed 5% withdrawal. This annuity runs out of value in about 26 years even with a projected 5% return on the annuity investments. If the client invested the money themselves and got the same 5% return and took the same $417 per month out for 26 years their portfolio would still have your original $100,000.
The alternatives would be to invest this money in a diversified portfolio of equities and fixed income at the appropriate level of risk for the couple and they could get potentially better returns and still have access to their portfolio should they need it.
One could even guarantee this stream of cash flows by building a ladder of US Treasury bonds even at today’s low interest rates and get these cash flows and have full access to their portfolio without any market risk.
These annuities may more attractive for older clients as the monthly payouts are higher because of “mortality credits”. With annuities, premiums paid by those who die earlier than expected contribute to gains of the overall pool and provide a higher yield or credit to survivors. The mortality credit increases significantly with age and hedges longevity risk. Remember the monthly payments are based on life expectancy so the older the client is the higher the payout for the same investment.
When you consider all of the factors above it is difficult to make a case for an immediate annuity for most clients.