Retirement Watch Lighthouse Logo

Pros and Cons of the New Annuities

Last update on: Dec 27 2018
pros-cons-of-the-new-annuities

Variable annuities long have been a controversial financial product. They became more controversial and confusing as insurers added features to make them attractive to more consumers.

The controversy heated up recently in the pages of Financial Planning, a magazine for financial planners.

It started with a white paper issued by Ibbotson Associates in October 2007 titled “Retirement Portfolio and Variable Annuity with Guaranteed Minimum Withdrawal Benefit.”

Variable annuities allow an investor to choose how the annuity is invested from among mutual funds or similar investment funds selected by the insurer. The value of the annuity rises and falls with the returns of the selected investments. Investors like the potential of earning more than a traditional fixed annuity but worry about the possibility of losses reducing retirement income.

One feature to reduce that worry is the GMWB. At withdrawal time, an annuity generally allows the owner to withdraw cash from the annuity each year up to a fixed percentage, usually 5%. As the name implies, when the account value declines, the owner may withdraw 5% of the cash value on the policy’s last anniversary date and can keep withdrawing 5% of that higher base. So, if the account declines for five consecutive years, the owner still can withdraw 5% of that higher base until the account recovers. The minimum withdrawal right continues even if the account declines to zero and below.

There are three points to keep in mind about the GMWB rider. The insurer incurs no costs unless the account value does reach zero. Until then the owner is withdrawing his or her own money. Effectively all the insurer is doing is waiving the limit to withdraw only a maximum of 5% of the current value. Also, there is no inflation adjustment to the guaranteed withdrawal.

Finally, the rider is not free. An insurer charges higher expenses for the rider. In addition, the fees might be calculated as a percentage of the higher value and not of the lower current value.

The white paper analyzed an annuity with a GMWB rider and developed the hypothesis that the annuity and rider will improve retirement income levels without increasing risk. Part of the controversy is that the study was funded by Nationwide Financial, a leading seller of variable annuities. This was fully disclosed in the paper. In addition, the white paper disclosed that the sponsor suggested the hypothesis.

Bob Veres, a columnist for Financial Planning, wrote an extended, critical analysis of the paper.
Veres said he was suspicious that the paper was slanted in favor of annuities when he saw that the comparison with mutual funds assumed that both the annuities and mutual funds were assessed 1% portfolio management expenses and 1% for a financial planner’s services. He believed these levels were too high for the funds and too low for the annuities. In addition, Veres said that the annuity expenses and the fee for the GMWB rider were well below those charged by top-selling annuities. The paper also did not take into account surrender fees paid on distributions taken before seven years have passed.

The white paper also did not account for taxes, according to Veres. After-tax results are critical, because annuity distributions are taxed as ordinary income, while mutual funds held in taxable accounts might be taxed at the long-term capital gains rate.

Another complaint Veres had was that the paper assumed that when a variable annuity was purchased it replaced the cash or money market portion of a portfolio of mutual funds. This change gives the variable annuity a higher long-term return than the mutual fund-only portfolio, making the annuity more attractive simply because of its higher equity allocation.

Veres said he recreated the calculations in the study, and then substituted what he believed were more realistic cost assumptions. He used two different assumptions, one more favorable to annuities than the other. In each case, the mutual fund portfolio had superior results and had steadier distributions than portfolio with an annuity.

Veres called one of the paper’s authors and was not satisfied with his answers to the concerns. Veres titled his column “Cheerleaders in Lab Coats” and concluded the study was “deeply flawed” because its assumptions favored annuities.

The co-author, Peng Chen, responded in the next issue of Financial Planning that the main purpose of the study was to develop the concept of longevity insurance. With longer life spans and the decline of defined benefit plans, retirees must develop ways to reduce the risk of running out of income. Annuities are one way to protect against longevity risk, but that protection carries a price. Mutual funds do not protect against longevity risk.

Veres also misunderstood or did not report fairly some other aspects of the white paper, Chen said. While Veres’ reproduction of one of the paper’s tables used a favorable investment period of 1979-2006, the conclusions in the paper were based on a Monte Carlo simulation assuming 5,000 scenarios. Investors need to plan for a lower return environment than the one used by Veres. Also, while Veres believed that individual expense assumptions were understated, Chen said its main assumption was a total expense ratio of 3%, which he defended as reasonable.

The downside protection of the annuities also was a key point in the report. This allows investors to use a more aggressive asset allocation in their annuity accounts, and the downside protection and guarantees make the annuity a logical substitute for the safe portion of an investor’s portfolio regardless of how the annuity is invested.

The treatment of income taxes could be improved, Chen concluded, but most investors have their assets in IRAs or 401(k)s. Those accounts are taxed the same way as annuities. Chen said that Veres completely misunderstood the point of the paper.

The argument continued for a third month. Veres wrote that he received analyses from a number of financial advisors, apparently all of which supported his position. He also said that TIAA-CREF is planning to introduce a GMWB rider to its annuities, but that it will charge much less than the typical rider. Veres’ source at TIAA-CREF also said that the breakeven point for the lowest cost annuities versus buying mutual funds is about 20 years.

Who’s right? Are these annuities with their riders a rip-off or worthwhile investment protection?

Longtime readers know that we believe variable annuities make sense only in select circumstances. The prospective annuity owner should exhaust all other tax-deferral opportunities (IRAs and 401(k)s). In addition, the investor should be aware that it will take at least seven years of compounding for the tax deferral of a low-cost annuity to overcome its higher expenses and tax burden. If the investor would only lightly trade mutual funds and pay only long-term capital gains on profits, or if a higher cost annuity were purchased, it would take longer than 10 years to reach the break even point.

As one of the responses to the articles stated, the real issue for investors is the cost-benefit trade off. The risk of running out of money is real. Even a well-selected portfolio of low-cost mutual funds could be depleted if the investor lives a long time and retires during an extended period of poor market performance. Insurers offer products to reduce the risk of running out of money in these circumstances. The products come with costs. The insurers will charge fees, and the investor also gives up the potential of higher returns if the markets do well.

Our job at Retirement Watch is to be sure investors understand the trade offs they are making, so that they are making informed choices. But it is up to each investor to decide which risks to take, which to shift to someone else such as an insurer, and how much to pay for shifting that risk. Insurers could do a better job of making the cost-benefit trade off clear and that is what our independent research does for you.

bob-carlson-signature

Retirement-Watch-Sitewide-Promo

Log In

Forgot Password

Search