Variable Annuity Plus Guaranteed Income Merits Careful Scrutiny
June 23, 2015 by TARA SIEGEL BERNARD
ASK retirees to design the perfect investment and it would surely be a guaranteed paycheck for life, providing protection in the market’s darkest hours, yet allowing them to profit during upswings.
A product that claims to achieve all of this, and often more, already exists: It is called a variable annuity with a guaranteed income rider — and the name itself, a mouthful, reflects its complexity. Variable annuities also are among the products most frequently sold to investors over age 65, according to a recent report by regulators, which also found evidence of potentially inappropriate sales to older investors at more than a third of the 44 brokerage firms examined.
The sales pitch can be hard to resist: Investors are guaranteed an income stream for life, with the possibility the amount will increase. If a retiree’s portfolio free-falls, no problem. He or she will still collect the same paycheck forevermore. That is because an insurance policy is attached to the investment portfolio, which guarantees the lifetime income.
But all of these promises come at a steep cost — 3.5 percent annually, on average, and often higher — which will gnaw at even the best-performing portfolios over time. So before signing any contracts, investors should first ask themselves if they fully understand what they are being offered. And then, they should weigh whether they could do better with a simpler investment.
Often, financial advisers say, the answer is yes. With many variable annuities, investors effectively pay more than 3 percent annually for the privilege of spending their own money. But older investors who want a guarantee that they will not outlive their portfolio may still find them attractive, even though the products available today are far less generous than those sold before the financial collapse of 2008.
“The thing with annuities is you are paying for insurance,” said Mark Cortazzo, a financial planner who offers an annuity review service. “And as with most insurance products, it’s the worst deal for some people, and for others it’s the best thing they could have done with that money.”
Perhaps, but it is a notoriously complex product typically sold by people working on commission who are not usually required to put your interests ahead of their own. And it is nearly impossible for average investors to figure out if they are getting a reasonable deal without professional help. Changing your mind can be costly, because many contracts carry hefty surrender charges, sometimes 7 percent of your portfolio or more.
Even Moshe Milevsky, an associate professor of finance at the Schulich School of Business at York University in Toronto who has studied the products extensively, said he had to consult with colleagues to figure out if he should add money to a variable annuity with a guaranteed withdrawal benefit.
“We needed two Ph.D.’s in math and some of their grad students to use their software normally used to analyze collapsing stars to figure it out,” he said, only half-jokingly. “I purchased it because I did the math and it looked like it was a good deal relative to other products.”
The money held in variable annuities with guaranteed income riders has doubled in the last five years to $843 billion in 2014, from $411 billion in 2009, according to the Limra Secure Retirement Institute, an industry research group. Sales were $67 billion last year, down from a peak of $96 billion in 2011, partly because some insurers have reduced their business.
So exactly how do they work — and how and when, if ever, should they be used?
Every contract has unique twists, but here is how a hypothetical variable annuity with a guaranteed income rider could operate. An investor makes an initial payment, say $200,000, which is then invested. The investor might choose to take withdrawals right away, or let the tax-deferred portfolio grow.
From here, it gets a little tricky. The size of the guaranteed paycheck is based on what you might think of as a “shadow account,” because its starting value mirrors the initial investment. But the shadow account, technically known as the benefit base, does not hold real money. It exists solely to calculate the amount of the investor’s paycheck.
The benefit base is usually guaranteed to grow by a set percentage, say 5 or 6 percent each year, until the investor starts collecting income. But if the investor’s actual portfolio is worth more than the base on a specific date each year, the benefit base will increase to that amount. If the market plunges, the real portfolio will suffer — but the shadow number and future paychecks will remain intact.
The guaranteed paycheck is a fixed percentage of the benefit base — perhaps 5 percent annually at age 65, or 4.5 percent for a couple — depending on the investor’s age when the income begins. The paychecks and hefty fees are deducted from the actual portfolio. If the portfolio is eventually depleted, the paychecks will continue based on the shadow account’s value, just as they always have.
“I think of it as draw-down insurance,” said Timothy Holmes, principal and head of Vanguard’s annuity and insurance services, which offers variable annuities and guaranteed income riders with total annual costs, about 1.75 percent, that are well below the industry average. “If the sequence of returns in the market are such that you deplete your assets, the insurance would pick up the payments going forward.”
There are far simpler annuities that may initially provide more generous income streams, including immediate or deferred-income annuities. Investors in those annuities hand a pile of money to an insurer, in exchange for a guaranteed paycheck for life, either right away or at some date in the future. But many investors balk at parting with so much money forever.
Some variable annuities with income riders, however, are far more flexible because investors can change their minds. If the stock market is strong — and a retiree decides she no longer needs the income guarantee — some riders or contracts can be canceled. However, many contracts charge harsh surrender penalties, which can last for the first seven years or longer so it is important for investors to know which kind they are buying.
That is why investors are told to invest aggressively, particularly when the annuity is part of a portfolio. Yes, this is the one instance where putting 100 percent in stocks is often recommended. The reason: No matter how far the market plunges, investors can still collect the guaranteed paycheck, which can never decline. If the portfolio rises with the markets, the paycheck will as well, which is why insurers increasingly cap the amount that investors may put in stocks.
“These types of products are a lot less attractive if you’re going to invest in a conservative portfolio,” said David Blanchett, head of retirement research at Morningstar Investment Management.
But that also means investors need to be comfortable watching their portfolio plummet in market downturns, while maintaining an unwavering faith in their insurer. One 77-year-old retiree from the New York area, who did not want to be named, could not handle the volatility during the market downturn in 2008 and 2009, even though his guaranteed income stream of 6.5 percent, or $39,000 annually, would continue until he was 85.
At that point, his contract required that he collect less, or 5.5 percent, a provision that he said had not been explained to him. He was not confident the lower amount, with diminished purchasing power from inflation, would be enough. After holding the annuity for two and a half years, he terminated his contract in 2012, paying a surrender fee of $42,000.
Stan Haithcock, an independent agent who specializes in annuities and calls himself Stan the Annuity Man, said that some brokers oversell the possibility that your paycheck can grow if the markets do well. They also overemphasize the guaranteed returns, which accrue to your benefit base (and not your actual portfolio), implying their money is growing at a high yield. More important, he said, is the promised percentage investors can withdraw.
“That is where the games are played,” he said. “You just need to focus on the very end number.”
He has another suggestion for consumers considering these products. After the broker is done with the sales spiel, summarize the product as you understand it. “Write it just as you hear it,” Mr. Haithcock said. “Sign and date it, and have them sign and date it. That is how you protect yourself.”
“By the way,” he said, “in most cases, they don’t sign.”
