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!
