Once again I'm electing to postpone my annual forecast for the economy and capital markets due to a more pressing issue - the need to debunk the slick variable annuity sales pitches making the rounds. Annuity salesmen from insurance companies such as The Hartford, Prudential and Mass Mutual, and stock brokers from the likes of E. D. Jones, Wachovia, and Morgan Keegan (Regions Financial) are preying on peoples' fear of running out of money before they die to sell them variable annuities. Variable annuities are expensive, restrictive, and usually poorly performing investment vehicles that were designed to shelter high-income earners from paying more taxes than absolutely necessary; they've morphed into guaranteed income investments for the elderly. However, they are wildly inappropriate for most individuals who are simply looking to ensure a certain level of income in retirement. At least one retired couple has learned to just say NO to variable annuities after getting a complete explanation of what these expensive insurance contracts actually could and couldn't do for them. The husband related how the E.D Jones broker was "pushy" when told that the insurance contract was about to be cancelled (during the free look period); clearly Mr. Broker didn't like the idea of losing his big, fat commission. Fortunately, the husband and wife had had a change of heart once they'd read the prospectus (which they finally received) and realized how much they were paying and how little they were actually getting once the boilerplate was boiled down to reality.
Nevertheless, the retired couple's basic problem still remains - how to earn a sufficient return on their savings to meet their retirement needs? (in a perpetually low interest rate environment that continues to punish savers and reward borrowers - thank you for nothing Federal Reserve!). Fortunately there is an answer that is far less expensive and far less restrictive than the Variable Annuity. It's called a diversified stock and bond portfolio!
A properly constructed, diversified portfolio will contain assets (stocks, commodities, real estate) that hedge against inflation in order to preserve purchasing power over the long run. The portfolio will also contain sufficient fixed income assets to generate a minimum level of current income to meet current liabilities. The wonderful thing about bonds is that they throw off a well defined stream of cash that can be used to meet liabilities as they come due! You don't even have to take credit risk if you stick with Treasuries and investment grade corporates and municipals. It is relatively easy for a qualified investment advisor (as opposed to a broker-dealer representative aka fee-based advisor) to construct a diversified bond portfolio that will yield 4% or so without taking any meaningful credit risk. As well, it is fairly easy currently to build a diversified portfolio of blue chip, dividend paying stocks with an average yield of 3.5%. The 4% rule tells us that a 60/40 stock/bond portfolio will last a minimum of 30 years, which gives us a starting point, at least, for positioning a portfolio for the decumulation phase of an investor's life cycle. The math: a bond portfolio yielding 4% and comprising 40% of the overall portfolio yields 1.6% to the investor, while a stock portfolio yielding 3.5% and comprising 60% of the overall portfolio yields 2.1% to the investor. Total yield of the 60/40 stock/bond portfolio is 3.7%.
Let's take a $1,000,000 portfolio as a case study to see what kind of current income we could generate while still positioning ourselves for a 30 year retirement. We would allocate $400,000 to bonds and currently could construct a portfolio of investment grade corporates and municipals that would give us an average yield of at least 4% with a duration of between 5 and 10 years. Interest produced would run at least $16,000 per year. We would allocate $600,000 to a diversified portfolio of blue chip stocks and could currently easily get a 3.5% average dividend yield, which would throw off at least an additional $21,000 in dividends. Total income generated by the entire $1,000,000 portfolio is at least $37,000, or approximately 3.7% per annum (almost meeting our 4% rule). Careful stock selection focusing on high-quality companies with well-covered dividends will provide an additional benefit in that the dividend income will rise over time as the companies raise dividends. Companies like Proctor and Gamble, Johnson and Johnson, Coke, and Microsoft can provide an annual and growing annuity unencumbered by the strait jacket restrictions placed on Variable Annuities sold by insurance companies.
And there you have it: a portfolio of stocks and bonds becomes that low-cost variable annuity that can provide a payout of (in this example) 3.7% per annum without touching principal - something you aren't allowed to do anyway in most variable annuities for between 5 and 10 years if you wish to qualify for the minimum income guarantee. The portfolio's overall yield will rise over time as the dividend paying stocks in the stock portion raise dividends regularly. Additionally, the 3% plus per year in average variable annuity expenses stays in your pocket rather than going to the insurance company. And finally, should your situation change and you need access to your money because of an unforeseen emergency... well, you have access without having to pay any of the penalties or forgo any of the guarantees.
One last thought:
Individuals with a shorter time horizon (less than 30 years) could construct portfolios with a greater allocation to bonds and reduced allocation to stocks, thus increasing the overall portfolio yield. Likewise, investors with excess wealth can reduce their allocation to stocks, if they wish to reduce variability in cash flows, since purchasing power risk isn't as much of a concern. After all, someone with $5 million of assets and a time horizon of only 15 years is likely to be able to survive on a 3% draw ($150,000) or even a 2% draw ($100,000) to meet everyday basic needs.
Our retired couple made a good call cancelling the annuity contract. They were looking at paying an up front commission of 3.5% and better than 3% annually in costs for a contract that was unlikely to benefit their income needs in any meaningful way. Now they need to construct a properly diversified stock and bond portfolio that will throw off sufficient income to meet their everyday needs while still protecting them from the long-term risk of inflation. By saying no to high-cost, restrictive and poorly-performing variable annuities and YES to low cost, flexible, diversified portfolios of blue chip stocks and bonds, our retired couple will get an acceptable level of income and still retain control of their assets!
Tuesday, November 24, 2009
Friday, November 13, 2009
The New Variable Annuities
I had planned on updating our macroeconomic view and laying out a likely course for the stock market over the next year, but have decided to put that blog on hold for a week in order to write once again about variable annuities. The catalyst for my change of mind? A seeming rash of variable annuity sales to folks who have no need for the expensive, restrictive, and even punitive insurance contracts (yes they are heavily regulated insurance contracts). The insurance sales representatives and the insurance companies themselves have stepped up their game and are preying on peoples' fear of running out of money before they die like never before. The seemingly too-good-to-be-true contracts are exactly that - too good to be true. Yet like the snake-oil salesmen of yesteryear, the variable annuity peddlers of today promise that these almost impossible to understand insurance products are the panacea for all that ails you.
Are you worried that you might end up in a long-term care facility? No problem! Your variable annuity will double the amount of your money you are allowed to take out if you do (if you pay extra for the privilege). Worried that you will run out of money before you die? No problem! Your handy dandy variable annuity will guarantee you a monthly payout for life (if you pay extra). Worried about dying early with your annuity investment under water? No problem! Your variable annuity will reimburse your beneficiary your original investment (if you pay extra and - in many cases - aren't 75 or older). Of course all of these guarantees come with a heavy price - most variable annuities will charge you more than 3% each and every year that you own the contract, although the fees are difficult to tease out of the offering documents and most people are blissfully unaware that they are paying so much for so little (an assertion that I will back up here shortly). Additionally, the investment choices given are usually extremely limited relative to the broad investment universe available to IRA owners, and typically are mutual funds that the insurance company manages in-house (more fees for them) or are managed by a "preferred provider" who kicks back fees to the insurance company (isn't that a cozy relationship?). And did we mention that these insurance contracts take a PhD in nuclear physics to understand?
There are now more than 1,100 different annuities on the market according to SmartMoney Magazine, up from 295 a decade ago. Variable annuities are suppose to be sold by prospectus because of their complexity and heavily regulated status, but the truth is many people aren't even aware that they are buying a variable annuity, or have only the vaguest idea of what they are buying. Russell Schellenberger was a successful business man who "didn't even know he'd bought one (variable annuity), according to Janet Paskin of SmartMoney. The word "annuity" hadn't even been mentioned during the sales process. It is a safe bet that Mr. Schellenberger wasn't given a prospectus, not that the highly legalized boilerplate would have necessarily enlightened him much. I'm a Chartered Financial Analyst (CFA)r with twenty years of forensic financial statement analysis under my belt. Nevertheless, I was recently put to the test on behalf of a nice, older couple who handed me their prospectus in the hope of getting an explanation of what they'd just purchased (They weren't given the prospectus before they signed on the dotted line, but instead received it after I explained to them that they were suppose to have gotten one and that the prospectus would explain the investment to them). After wading through the legal document I can honestly claim that I was only half right... they were suppose to have gotten a prospectus.
It's important to understand that the new-age variable annuity is an expensive, yet untested product. Traditional insurance works by using large numbers of people to spread risk out; the insurance company keeps the difference between the premiums collected and the insurance paid out. Variable annuities concentrate risk in the stock market. There is more than a little concern within the industry that insurance companies will not be able to meet their obligations if the stock market continues to under perform expectations. York University professor Moshe Milevsky has studied annuities for decades and believes that the new products are under priced to cover the cost of protecting investors in a crash. Moody's has raised red flags recently over concerns that insurance companies will not be able to meet their promises to investors under plausible worst case scenarios. And annuities do fail. Exhibit A is U.K. Equitable, a major British insurance company. U.K. Equitable was forced to sharply reduce the minimum guaranteed payout to annuity holders in the late 1990's because interest rates didn't do what actuaries had predicted.
Turns out then that the minimum income guarantee that is available (for an extra cost) is only as good as the financial strength of the insurance company selling the annuity. But what about the basic product itself (assuming that the insurance companies will survive the next big downturn in the stock market) - is the minimum income guarantee really a panacea for investors who have under saved and are now worried that they will outlive their assets? The answer is not really. Here's how the typical product works these days:
An investor buys a variable annuity, placing the money into an investment account that then disburses the money to sub accounts composed of typically high cost mutual funds (remember that cozy relationship between the insurance company and the either captive mutual funds or "preferred providers"?) The mortality and expense fees for the variable annuity usually run around 1.65% per year while the underlying funds usually suck out another 1.5% to 2.0% of the investors money every year. A 3.0% plus per annum expense ratio is a high hurdle to overcome and almost guarantees under performance of the contract relative to owning individual stocks and bonds or low cost, no-load mutual funds. Your broker is often receiving the 12b-1 trailers on the funds in which you invest inside the variable annuity by the way.
Your investment account is left to grow, and the insurance company hopes it grows sufficiently to cover the guaranteed income payments once you start to take them down the road. One product I recently reviewed for an investor had been bought when the investor was 60 years of age. He was guaranteed a minimum income benefit of $30,000 per year if he left the money in place for at least 10 years. He bought a $300,000 variable annuity which was placed into stock mutual funds. The insurance company moved the bulk of the money into a fixed account earning 2% per annum when the bottom fell out of the market in 2008 - it will remain their for the rest of the contract life in order to protect the insurance company. The investor will be allowed to take $30,000 of his own money out of the contract every year until he dies, starting when he turns 70. Of course, the average life expectancy for a man of his socioeconomic background and health is around 78. It is still barely possible that his investment account will make it back close to the original $300,000 level before he turns 70, since he does still have $29,000 invested in stock mutual funds within the annuity - perhaps it will double in the next 8 years, although that is unlikely.
Regardless, this investor has taken $300,000 from his tax deferred IRA (in which he had absolute freedom to invest in any number of low cost mutual funds or directly in a portfolio of blue chip stocks) and put the money into a restrictive, condition-filled insurance product that might actually return all of his original investment to him by the time he turns 80 (if he lives that long and the insurance company is still solvent). Should he manage to make it to 85-years of age he will have hit the jackpot! By 85 he will have been allowed to withdraw $450,000 over a 15-year period (some of the money likely the insurance company's). Whoop dee do!
Why the facetious celebration? Do the math! Our investor will have taken out $450,000 from an original investment of $300,000 made 25-years earlier. A fifty percent gain over 25- years comes to exactly 2% per annum compounded (and that's before paying income tax on the withdrawals). You can better than double that return right now in 20-year tax-free Treasuries, and easily construct a bond portfolio that allows you a substantially higher guaranteed income stream than the annuity, without the onerous restrictions placed on you by the insurance companies - who might not even be in business in 25-years!
Yep! Ya really gotta love those variable annuities and the snake-oil salesmen who peddle them!
Are you worried that you might end up in a long-term care facility? No problem! Your variable annuity will double the amount of your money you are allowed to take out if you do (if you pay extra for the privilege). Worried that you will run out of money before you die? No problem! Your handy dandy variable annuity will guarantee you a monthly payout for life (if you pay extra). Worried about dying early with your annuity investment under water? No problem! Your variable annuity will reimburse your beneficiary your original investment (if you pay extra and - in many cases - aren't 75 or older). Of course all of these guarantees come with a heavy price - most variable annuities will charge you more than 3% each and every year that you own the contract, although the fees are difficult to tease out of the offering documents and most people are blissfully unaware that they are paying so much for so little (an assertion that I will back up here shortly). Additionally, the investment choices given are usually extremely limited relative to the broad investment universe available to IRA owners, and typically are mutual funds that the insurance company manages in-house (more fees for them) or are managed by a "preferred provider" who kicks back fees to the insurance company (isn't that a cozy relationship?). And did we mention that these insurance contracts take a PhD in nuclear physics to understand?
There are now more than 1,100 different annuities on the market according to SmartMoney Magazine, up from 295 a decade ago. Variable annuities are suppose to be sold by prospectus because of their complexity and heavily regulated status, but the truth is many people aren't even aware that they are buying a variable annuity, or have only the vaguest idea of what they are buying. Russell Schellenberger was a successful business man who "didn't even know he'd bought one (variable annuity), according to Janet Paskin of SmartMoney. The word "annuity" hadn't even been mentioned during the sales process. It is a safe bet that Mr. Schellenberger wasn't given a prospectus, not that the highly legalized boilerplate would have necessarily enlightened him much. I'm a Chartered Financial Analyst (CFA)r with twenty years of forensic financial statement analysis under my belt. Nevertheless, I was recently put to the test on behalf of a nice, older couple who handed me their prospectus in the hope of getting an explanation of what they'd just purchased (They weren't given the prospectus before they signed on the dotted line, but instead received it after I explained to them that they were suppose to have gotten one and that the prospectus would explain the investment to them). After wading through the legal document I can honestly claim that I was only half right... they were suppose to have gotten a prospectus.
It's important to understand that the new-age variable annuity is an expensive, yet untested product. Traditional insurance works by using large numbers of people to spread risk out; the insurance company keeps the difference between the premiums collected and the insurance paid out. Variable annuities concentrate risk in the stock market. There is more than a little concern within the industry that insurance companies will not be able to meet their obligations if the stock market continues to under perform expectations. York University professor Moshe Milevsky has studied annuities for decades and believes that the new products are under priced to cover the cost of protecting investors in a crash. Moody's has raised red flags recently over concerns that insurance companies will not be able to meet their promises to investors under plausible worst case scenarios. And annuities do fail. Exhibit A is U.K. Equitable, a major British insurance company. U.K. Equitable was forced to sharply reduce the minimum guaranteed payout to annuity holders in the late 1990's because interest rates didn't do what actuaries had predicted.
Turns out then that the minimum income guarantee that is available (for an extra cost) is only as good as the financial strength of the insurance company selling the annuity. But what about the basic product itself (assuming that the insurance companies will survive the next big downturn in the stock market) - is the minimum income guarantee really a panacea for investors who have under saved and are now worried that they will outlive their assets? The answer is not really. Here's how the typical product works these days:
An investor buys a variable annuity, placing the money into an investment account that then disburses the money to sub accounts composed of typically high cost mutual funds (remember that cozy relationship between the insurance company and the either captive mutual funds or "preferred providers"?) The mortality and expense fees for the variable annuity usually run around 1.65% per year while the underlying funds usually suck out another 1.5% to 2.0% of the investors money every year. A 3.0% plus per annum expense ratio is a high hurdle to overcome and almost guarantees under performance of the contract relative to owning individual stocks and bonds or low cost, no-load mutual funds. Your broker is often receiving the 12b-1 trailers on the funds in which you invest inside the variable annuity by the way.
Your investment account is left to grow, and the insurance company hopes it grows sufficiently to cover the guaranteed income payments once you start to take them down the road. One product I recently reviewed for an investor had been bought when the investor was 60 years of age. He was guaranteed a minimum income benefit of $30,000 per year if he left the money in place for at least 10 years. He bought a $300,000 variable annuity which was placed into stock mutual funds. The insurance company moved the bulk of the money into a fixed account earning 2% per annum when the bottom fell out of the market in 2008 - it will remain their for the rest of the contract life in order to protect the insurance company. The investor will be allowed to take $30,000 of his own money out of the contract every year until he dies, starting when he turns 70. Of course, the average life expectancy for a man of his socioeconomic background and health is around 78. It is still barely possible that his investment account will make it back close to the original $300,000 level before he turns 70, since he does still have $29,000 invested in stock mutual funds within the annuity - perhaps it will double in the next 8 years, although that is unlikely.
Regardless, this investor has taken $300,000 from his tax deferred IRA (in which he had absolute freedom to invest in any number of low cost mutual funds or directly in a portfolio of blue chip stocks) and put the money into a restrictive, condition-filled insurance product that might actually return all of his original investment to him by the time he turns 80 (if he lives that long and the insurance company is still solvent). Should he manage to make it to 85-years of age he will have hit the jackpot! By 85 he will have been allowed to withdraw $450,000 over a 15-year period (some of the money likely the insurance company's). Whoop dee do!
Why the facetious celebration? Do the math! Our investor will have taken out $450,000 from an original investment of $300,000 made 25-years earlier. A fifty percent gain over 25- years comes to exactly 2% per annum compounded (and that's before paying income tax on the withdrawals). You can better than double that return right now in 20-year tax-free Treasuries, and easily construct a bond portfolio that allows you a substantially higher guaranteed income stream than the annuity, without the onerous restrictions placed on you by the insurance companies - who might not even be in business in 25-years!
Yep! Ya really gotta love those variable annuities and the snake-oil salesmen who peddle them!
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