Meditations on Money Management

Andrew Silton: Purchase an annuity if you are trying to manage a specific risk

CorrespondentJune 28, 2014 

If you spend any time reading financial publications, you can find just as many ringing endorsements of annuities as you’ll find articles panning them. The annuity has been part of the investment scene for decades, although the product has taken many forms over the years.

In its pure form, an annuity is an insurance contract in which the beneficiary receives a series of payments in exchange for paying a premium. However, many annuities are far from simple, because they embed investment options and other features.

Like most financial products, complicated annuities can be difficult to evaluate and offer all too many opportunities to charge performance-draining fees. Are annuities to be avoided? No. Annuities can play a role in the financial plans for some investors.

I’ve been thinking about a column on annuities for a long time. However, it’s a rather difficult topic because so much depends on the specific terms and conditions of a particular product. Except for the most basic annuity products, you’ve either got to be prepared to do a lot of work analyzing and comparing products, or have a high level of trust in your financial adviser. Nonetheless, I thought it might be useful to spend one Sunday discussing the world of annuities.

What’s your problem?

Buying an annuity is a bit like buying a car. If you go into a car dealer without a good idea of what you are looking for and the options you are interested in adding to the basic vehicle, you are going to pay a whole lot of money for something you don’t really need.

The annuity poses many of the same dangers. For starters, you shouldn’t let anyone talk to you about buying an annuity until you are clear about the problem you are trying to solve. Are you trying to build up your retirement assets? Or are you attempting to create retirement income? There’s a set of annuity products that might be appropriate to supplement your 401(k) or IRA, and another set of products to augment Social Security and your other sources of retirement income. Moreover, you should also try to figure out whether you can achieve the same or a similar result using conventional investment products. They almost always offer more flexibility at less cost than annuities.

The annuity is a contract, and it is going to have terms and conditions that make it difficult or expensive to terminate. Often there’s a large price to pay (a surrender charge) if you change your mind, especially with products that have a lot of features. More importantly, you are going to have to pay a mortality and expense (M&E) charge to cover the insurance aspect of the annuity, pay for administration, and/or compensate the financial adviser. These fees vary widely and are in addition to fund expenses if the annuity has an imbedded investment feature.

Typically folks purchase annuities because they’re worried about a risk. For example, an investor might be concerned about suffering losses if the stock market declines. A retiree might be anxious about outliving her assets or being unable to leave an estate to her heirs. If you don’t think about these issues in advance, a savvy salesman will turn your worries into fears and wind up selling you all sorts of bells and whistles. In my experience, most annuities become financially unattractive when they attempt to simultaneously address multiple risks. If you try to address every conceivable risk through an annuity, you are probably better off not buying one.

Let’s assume you are trying to build up your retirement nest egg; you might consider investing in a deferred variable annuity. As the name implies, your results will vary depending on your investment choices. The tax on any gain is deferred until the capital is withdrawn. However, until you’ve maximized your 401(k) and/or IRA contributions, there’s no reason to consider an annuity. The 401(k) and IRA are less expensive than annuities when it comes to generating tax-deferred retirement savings.

Gauging tax benefits

Furthermore, the tax deferral feature shouldn’t overly entice you, even though many financial advisers will show you marketing materials that “demonstrate” the huge tax advantage of the product. While it’s potentially beneficial to use a very active equity mutual fund inside an annuity because the annuity shields a great deal of ordinary income generated by the portfolio manager, I’ve found that you can beat a deferred annuity if you use low-cost index funds in a regular taxable account. You come out ahead because the fees are substantially lower, and a large proportion of your profits are taxed as capital gains. While deferred variable annuities usually offer all sorts of mutual fund options, the product has little value if you’re going to adopt a conservative asset allocation, since the expenses more than eat up any tax advantage. You’re usually better off buying a bond fund or considering some type of fixed deferred annuity.

Some of these products offer downside protection along with some participation if the stock market rises. Folks tend to pile into these products after a stock market decline, and then regret it because their returns are anemic in a rising market. When they decide to swap out of the product, they face the aforementioned surrender charge. If you’re worried about market volatility, you’re probably better off holding a larger allocation to fixed income or cash rather than investing in one of these hybrid annuities.

Let’s switch gears and assume you are approaching retirement, and you don’t have a corporate or public defined benefit plan. How can you create a steady income stream for your lifetime and the lifetime of your spouse? Before the era of low interest rates, investors could get the job done with a laddered bond portfolio or fixed income mutual fund. Today, many retiring investors fear that they’ll outlive their assets. As a result, the income annuity has become a hot product. In exchange for putting up a large sum, the insurance company guarantees a monthly income for the lifetime of the beneficiaries. The product isn’t a panacea, but it can form part of an investment plan to provide some level of guaranteed income. In my estimation, the income annuity shouldn’t represent more than 10 percent of your overall investment portfolio.

Supplemental income

While the income annuity attempts to address the risk of running out of money (assuming the insurance company remains solvent and the state insurance fund is adequate), the investor has to accept that the insurance will have been very expensive if the investor doesn’t live to a ripe old age. The product works because it is pooling the risk of thousands of people. The premiums and earnings from those who die earlier than expected help pay for the folks who live beyond expectations.

A note of caution: Unless the product has an inflation adjustment (often an expensive feature), the real value of the monthly income may be vastly diminished over a 20- or 30-year period. Nonetheless, the income annuity can play a useful role in supplementing other sources of income. Like many other investment solutions, the product tends to be most affordable if you purchase it well before you intend to draw on it. Moreover, the advantages of the product diminish if you start adding features to the product, such as a cash refund option.

I know it is an oversimplification, but I think investors are best served if they separate their insurance needs and investment requirements. In other words, purchase an annuity if you are trying to manage a specific risk, much as you’d purchase life insurance. Invest in stocks, bonds, mutual funds, and ETFs to meet your investment needs. Be wary when the insurance product combines an annuity and investment product into a single bundle.

Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/

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