Mention the word “annuity” at a social gathering and you are likely to get a wide range of reactions ranging from “expensive” and “loss of control,” to “lifesaving” and “sleep at night comfort.” As with most things in life, the truth may not really be black and white but shades of gray between the extremes. For a growing number of those either in or planning for retirement, “… the life-time income guarantees offered by these insurance company products can add security to portfolios…” according to a Wall Street Journal report.¹ A surprising comment coming from a leading publication that prior to the 2007-2008 financial crisis had been a long-term critic of these programs.
The word “annuity” itself often conjures different perceptions, some accurate and some not. A common and perhaps traditional view is that of a contract wherein an investor can receive lifetime income in exchange for relinquishing ownership (and control) of a lump sum of money. So, as the thinking goes, if the investor lives a long time, he can do well. By contrast, should he die prematurely then the insurance company makes out.
While this perception may be at the base of their historic roots, the reality is that these products have benefited from many innovations particularly in recent years. Certainly all annuities involve a contract between the investor and an insurance company. Beyond that, the word “annuity” can embrace a wide range of products, some more beneficial than others depending on the specifics of your situation.
So before making a decision, it is important to be aware of these thirteen critical considerations:
- Immediate versus Deferred
As noted above, some annuities provide their cash flow benefit right away, hence the term “immediate” annuity. They offer simplicity and predictability. By contrast, others may postpone their benefit until a future date and thereby provide an opportunity to accumulate. These are called “deferred” annuities and can offer a potential for growth as well as future income.
2. Fixed versus Variable
The way annuities accumulate value can be based on a stated interest rate (fixed), on the performance of some underlying investments (variable) or a combination of the two.
- Fixed: It is important to carefully review the different interest rates and timeframe for which those are offered.
- Variable: We need to focus on a number of aspects including:
- Investment Options: For those programs that allow us to select from among a variety of investment options or funds, it is important to research how well these are regarded by independent rating firms such as Morningstar. Having more higher rated funds available with a broad range of objectives can give us flexibility to adjust our investment program as needed.
- Flexibility to Select: What restrictions exist on selection both in terms of which funds and how often can they be changed?
- Investment Control: To help control their risk, some insurers may stipulate that they have the power to move money from our designated investments into either fixed accounts or funds that they manage.
- Hybrid: Some programs such as Equity Index (EIA’s)² may combine these programs, i.e. provide the principal stability of a fixed annuity with their earnings based on a portion of the upward movement of a market index. Considerations include:
- Investment Options: What indices are available?
- Performance Restrictions: Especially during periods of low interest rates, it is important to understand what restrictions or “Caps” may limit the upside earnings potential.
- Living Benefit Guarantees
Can come in several forms, each provides us with a contingency plan should the investments not perform well:
- Account Value: Herein the insurer is promising to provide us a specific lump sum amount at a specified time. This is referred to as a Guaranteed Account Value, or GAV.
- Income Benefit: This allows us to convert our account balance into an income stream that could last a lifetime, for multiple lifetimes, for a specific time period, or a combination of these. Since the investment is replaced with this income stream, we would unfortunately not benefit should the investment value increase in the future. Options of this type are called Guaranteed Income Benefits or GMIB.
- Withdrawal Benefit: By contrast, this option may allow us to create a cash flow which includes our current account balance plus future earnings. Called a Guaranteed Withdrawal Benefit (GWB), the cash flow may continue until the “withdrawal base” is depleted. The duration of that cash flow may be extended if our investments perform.
- Hybrid: Recent innovations have created programs whereby the strengths of these can be combined to give us the best of all worlds. For example, a “Guaranteed Lifetime Withdrawal Benefit (GLWB)” can provide that if the investment account does deplete the insurer will step in and guarantee that the cash flow continues for the rest of our life. This in essence combines elements of the GMIB with those of the GWB.
- Death Benefit Guarantees
While most often known for their living benefits, annuities can provide a range of death benefits as well. Typical base is to offer the greater of the original deposits less withdrawals or current market value. For additional cost, there may be a broad array of enhancements as well.
- Minimum Accumulation Rates
Some programs may offer a minimum rate at which the guaranteed income base will grow each year even if there is no investment performance. While attractive, it is important to keep in mind that these increases will only be of benefit when the guaranteed income commences. As such they are not “walk away” increases to the investment account that would be available if the contract were liquidated.
- Distribution Rates
At a point in time when we want to start taking guaranteed cash flow, we will find that insurers may limit that cash flow to a certain percentage of the guaranteed value each year. With some insurers, this may be based on the annuitant’s age.
- Costs and Expenses
Fees will differ depending on the type of annuity:
- Fixed and Equity Index programs often have no fees charged to the investor. The interest rate or “caps” will have the insurers revenue already included.
- Variable contracts typically have a number of fees including but not limited to; mortality, administration and fund expense. It is important to be aware that because these programs offer more, they tend to be more expensive than non-annuity investments. As such, it is important that we be aware of the fees and carefully evaluate whether they are justified by the benefits for each individual situation.
- Surrender Charges and Liquidity
In lieu of initial commissions or fees, many annuities will have the ability to asses a schedule of charges when money is withdrawn and have that ability last for a specified period of time. Depending on the contract, surrender periods may last 0-10 years or longer. Shorter surrender periods typically involve lower interest rates or “caps” for fixed and index annuities and greater costs for the variable; hence it is important to carefully consider our timeframe and liquidity needs when making this decision.
- Advisor Compensation
How is the sales person or advisor paid? For those who receive their commission or fees initially, this may reduce the incentive to provide guidance later when needed. By contrast, advisors who receive their compensation over time (often called a recurring fee) will have financial incentive to provide guidance on an on-going basis.
- Proprietary Programs
Advisor objectivity can be clouded when his/her employment firm is the same one that offers investment and annuity products. Conflicts like this can be reduced if the advisor is independent of the insurer. It is also a good idea to have the flexibility to change insurers should the current one experience problems, and/or if new, more attractive products become available.
- Insurer’s Financial Strength
Since the guarantees may be as good as the insurer is solvent, it is important to know the insurer’s ratings and ability to manage risk. Guarantees are subject to the claims-paying ability of the issuing insurance company. Ratings assigned to any issuing entity are subject to change and do not apply to any of the underlying investment options of annuity products.
- Long-Term Health Care
As our population ages, more insurers are providing additional options to support a long term care situation should it arise. This may come in the form of enhanced pay out benefits or waiver of surrender charges.
- Insurer Service
Since annuities are a long-term investment, we are dependent on the insurer to deliver a high service quality not just at the onset but for years to come. How available are they to not only provide service but also answer questions as they arise?
With our longer life expectancies there is an increased risk of running out of money. When we combine that with investor discomfort from the economic uncertainty over the recent years, we are finding more clients receptive to the benefits that annuities offer. That said, it is critical that before purchasing an annuity clients carefully weigh their circumstances including time horizon, liquidity needs, income goals and risk tolerance, some benefits may be more appropriate than others. Also important to keep in mind is that this list contains items of which clients should be aware; as such it is by no means comprehensive. Readers are encouraged to discuss details with their advisors and insurers.
Uncertainty over the economy and financial markets has many people concerned about their financial futures. For friends, relatives and colleagues who may find this information helpful, please feel free to share with them. Remember, for those who could benefit we offer a complimentary, no obligation “Second Opinion” that can offer an objective financial review. Keep us in mind for those who may be seeking a wealth management firm like ours—one that delivers services according to the needs and perspectives of its clients.
This information is not considered a recommendation to buy or sell any investment or insurance and is being provided for information purposes only and is not a complete description, nor is it a recommendation. We strongly recommend an advanced tax and estate planning expert be contacted for further information since Wells Fargo Advisors Financial Network LLC (WFAFN) does not provide tax or legal advice. Any opinions are those of Mitchell Kauffman and not necessarily those of WFAFN. The information has been obtained from sources considered to be reliable, but Wells Fargo Advisors Financial Network does not guarantee that the foregoing material is accurate or complete. Prior to making a financial decision, please consult with your financial advisor about your individual situation. Investment products and services are offered through Wells Fargo Advisors Financial Network LLC (WFAFN)/Member SIPC. Kauffman Wealth Management is a separate entity from WFAFN.
Variable annuities are long-term investment alternatives designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if made prior to age 59-1/2, may be subject to a 10% federal tax penalty. Early withdrawals may be subject to withdrawal charges. Partial withdrawals may also reduce benefits available under the contract as well as the amount available upon a full surrender. An investment in variable annuities involves risk, including possible loss of principal. The contracts, when redeemed, may be worth more or less than the original investment.
The Income/Benefit bases do not guarantee a cash or account value, cannot be taken as a lump sum, and do not guarantee a minimum return for any portfolio.
Mitchell Kauffman, Managing Director
Certified Financial Planner™
Mitchell Kauffman provides wealth management services to corporate executives, business owners, professionals, independent women, and the affluent. He is one of only five financial advisors from across the U.S. named to Research magazine’s prestigious Advisor Hall of Fame in 2010, and among a select list of 100 over the past 20 years.
Inductees into the Advisor Hall of Fame have passed a rigorous screening, served a minimum of 15 years in the industry, acquired substantial assets under management, demonstrate superior client service, and have earned recognition from their peers and the broader community.
Kauffman’s articles have appeared in national publications, and he is often quoted in the media. He is an Instructor of Financial Planning and Investment Management at the University of California at Santa Barbara and Santa Barbara City College.
For more information, visit www.kauffmanwm.com or call (866) 467-8981. Kauffman Wealth Management and serves clients from two office locations: 140 South Lake Avenue, Suite 307, Pasadena, CA 91101 and 550 Periwinkle Lane, Santa Barbara, CA 93108 (by appointment only). Investment products and services are offered through Wells Fargo Advisors Financial Network LLC (WFAFN). Kauffman Wealth Management is a separate entity from WFAFN.
1“Making the Case to Buy an Annuity,” by Lavonne Kuykendall, Wall Street Journal 3/8/11
2 EIAs are complex financial instruments that have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity. Many insurance companies only guarantee that you’ll receive 87.5% of the premiums you paid, plus 1 to 3 percent interest. Therefore, if you don’t receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if you surrender your EIA before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early. (Taken from FINRA Investor Alert: Equity-Indexed Annuities – A Complex Choice)