I frequently write about new financial products that are designed to fleece investors. But this month I want to draw your attention to an older product that costs consumers a bundle. It’s called an annuity. I am not a fan. At Cardiff Park we field many questions about annuities, and believe it’s time to pull back the curtain to explain their enticing trickery. Take a seat, because this blog is longer than usual. We’ll review April numbers at the end.
Every investor wants steady, reasonable returns without high risk or undue pain. Is that too much to ask? Not if you’re an annuity salesman. An annuity is a complex insurance product often marketed to middle-aged and older investors with promises to achieve something extraordinary with their money. In exchange for a lump-sum payment you receive certain pledges from the insurer, typically including a mix of periodic income streams, on-demand withdrawals, minimum stated returns, and sometimes a death benefit. Appealing, right? Don’t clap yet.
The sales pitch rarely mentions punitive annual costs, severe restrictions, the ability of the issuer to invoke contract changes after you sign, and other downside risks buried in the fine print. The prospectuses and disclosures for annuities stretch to hundreds of pages, always a red-flag warning. While annuities are often touted as “tax-sheltered” products, taxes are levied when funds are withdrawn, even after death (your heirs will not thank you). While getting into an annuity is easy, getting out of one before the maturity date is costly. Meanwhile, riders add significantly to high overall costs.
Little wonder that consumer complaints about annuities center on lack of disclosures about what they were buying, particularly for variable annuities. According to Tara Siegel Bernard in the New York Times, variable annuities are one of the most popular financial products sold to investors over the age of 65, with “evidence of potentially inappropriate sales to older investors at more than a third of 44 brokerage firms examined,” according to a 2015 regulatory report.
What’s clear about annuities is that they are far too complex for the average consumer to understand, much less purchase, without an unbiased and thoroughly informed financial advisor by his or her side. This isn’t to say annuities are wrong for everybody. They’re just wrong for most people.
Unfortunately, annuities can be very appealing to investors looking for guaranteed retirement income (and who isn’t?). We’re in the midst of the biggest retirement boom in history. Since January 2011, when the oldest Baby Boomers reached 65, we can expect about 10,000 more Boomers to hit age 65 every day for the next 19 years, according to the Pew Research Center. This aging population is more vulnerable than ever as consumer safeguards are being dismantled or undermined by the Trump administration. It’s a good time to be an annuity salesman.
Without going too deep, let’s take a look at the variety of annuity products and some good reasons to stay away—at least until you’re willing to read, ponder and weigh the risks compared to other investment options.
What is an annuity?
An annuity is typically a contract between you and an insurance company, with the goal of providing a steady stream of income during retirement. In exchange for a lump sum payment or series of payments, the buyer gets regular disbursements beginning either immediately or at some point in the future. There are many different annuities marketed by many different insurers. The three basic varieties are:
• Fixed annuities. These pay a fixed or guaranteed minimum rate of interest for a set period of time, essentially like CD investments. They appeal to conservative investors, though as we’ll demonstrate later, other less restrictive investments may deliver superior results.
• Indexed Annuities. These combine elements of a fixed annuity and a variable annuity. An indexed annuity offers the low-risk appeal of a guaranteed minimum fixed return with some upside based on a specific market benchmark. There’s generally a cap on the portion of market return that the owner will receive.
• Variable Annuities. These allow a lump sum to be invested in sub-accounts, similar to a mutual fund, and may move up or down with the market. Variable annuities may offer a guaranteed minimum rate of return even when the underlying principal is underperforming. However, fees and other costs can have a damaging impact on investment returns.
So far so good. Principal in, steady income out. Now let’s look at the fine print.
Know the Terms that Affect Returns
• Participation Rates. A participation rate determines how much of the gain in the index will be credited to the annuity. For example, the insurance company may set the participation rate at 80 percent, which means the annuity would only be credited with 80 percent of the gain experienced by the index.
• Minimum Returns. This is the minimum rate of return the annuity will earn. It’s typically tied to the long-term annualized average return of the market index underlying an indexed annuity
• Performance Caps. This is the maximum rate of interest the annuity will earn. For example, if the index linked to the annuity gained 10 percent and the cap rate was 8 percent, then the gain in the annuity would be 8 percent
How Performance Floors and Caps Dampen Returns
Floors protect investors from losing too much when the market moves down a lot, while caps protect the insurance company from paying out too much when the market moves up a lot. This can lead to steadier returns, but smooth growth often comes at a high price. Keep in mind that variable annuities are meant to be long-term investments.
Let’s say you invested $300,000 twenty years ago in an indexed annuity (blended 70/30 between stock and bond indexes), with a 1% floor, a 5% return cap, and a 100% participation rate. The value would have doubled to $630,000 over that span of time. Sounds great! But that’s much less than you would have made by investing in either the bond or stock component of a blended portfolio. Investing $300,000 in the bond index would have resulted in $840,000, or 33% better returns. Investing $300,000 in the stock index would have resulted in $912,000, or 45% better returns.
This is just one example, and every annuity is different. Different floors and caps produce different results. The important point is that while smoother returns sound attractive, caps on the upside can outweigh the benefits of floors on the downside. The annuity holder gains an element of safety, but at a high cost to long-term results.
Riders: High Cost, Many Restrictions
Anyone who has purchased insurance understands the benefit of riders. For instance, a jewelry rider on a homeowner’s policy. But with annuities, riders must be carefully evaluated. They add tremendous expense (more on that in a moment). Some tend to be useful only if your annuity performs poorly, and some have strict conditions or force irrevocable decisions that aren’t in your best long-term financial interest. Typical riders include a Guaranteed Minimum Death Benefit, a Guaranteed Withdrawal for Life, and a Guaranteed Minimum Income Benefit. Many riders have a waiting period that begins only after the period in which you’d incur early withdrawal fees ends, sometimes as long as ten years after purchase. Consider that you’ll pay for that rider every single year and the benefits are typically exaggerated.
Punitive Early Withdrawal Fees
Hate front-loaded mutual funds? Then the huge early withdrawal surrender fees (often 8% or more) on most annuities should give you pause. Before buying an annuity, be certain you can keep the money locked up for the entire contract, or be prepared to pay. Some annuities let you withdraw small amounts each year without penalty, so read the fine print. Still, it may be wiser to withdraw nothing at all. Many contracts state that when you reset your roll-up benefit base, a new waiting period to exercise the Guaranteed Minimum Income Benefit (GMIB) applies from the date of the reset. You could be in a perpetual waiting period if you’re not careful.
Taxing, Even for Heirs
Annuities aren’t subject to taxes year by year, but when withdrawn they are subject to taxes. Never mind that you paid the premium with after-tax dollars. The withdrawals should be tax-free, but they aren’t. There’s no step-up cost basis, either, so your heirs can expect to be saddled with paying taxes after you die. If they are in a high tax bracket, being the beneficiary of an annuity may be no gift at all.
Brace yourself. In addition to hefty early surrender charges, an annuity can easily cost an investor 4.00% or more in annual fees. These fees go to the insurance company, the investment company and the distributors. Here’s a typical breakdown:
• Mortality & Expense Risk — 1.10% annually
• Administrative Fees — 0.35% annually
• Optional Guaranteed Minimum Death Benefit — 1.30% annually
• Optional Guaranteed Minimum Income Benefit Rider — 1.30% annually
• Fund Expense for Underlying Funds in Variable Annuity — 1.5% annually
• Total Cost: 4.25% annually
Over time, that 4.25% in annual fees can make a huge difference in performance. John Bogle has called it “the tyranny of compounding costs.” Calculating the impact of annuity expenses does indeed reveal a cruel result.
Let’s compare the total returns of a 70/30 Blended Index first to an identical Blended Index, minus 0.77% in annual mutual fund expenses, and second, to the Blended Index minus the hypothetical annual costs from the Variable Annuity described above. Over the past 20 years, $300,000 invested in the Blended Index would have grown to $939,000, versus $804,000 after adjusting for the mutual fund expenses. But after taking into account the hypothetical annual costs from the Variable Annuity, that $300,000 would have grown to only $393,000. That’s just 42% of the ending value of the Blended Index. In dollar terms, it’s a whopping $546,000 shortfall over 20 years.
Still Searching for the Holy Grail?
You aren’t going to find it in annuities. Like most financial products, annuities were not created to serve your best financial interests. The people selling these products are not registered investment advisors or fiduciaries. They’re brokers and salespeople. Their lobby is powerful and the profits and fees they earn are tremendous.
As always with fancy financial products, the allure of annuities has much to do with savvy marketing and popular spokespeople (the motivational speaker Tony Robbins is one of the latest). Celebrity endorsements notwithstanding, annuities are likely to bring more pain than gain for most people. The complexity of annuities always favors the issuers. Buyers are inadequately compensated for the loss of liquidity, and pay dearly for pledges received in return for lump sum payments. Even when annuities work out, it can take a long, long time.
But don’t feel terrible if you own one. Sometimes, remaining in a policy could be your best course of action after a decade or two. The commissions and fees are water under the bridge by now, so you may as well take what you can get, especially in our current era of low interest rates. Cardiff Park Advisors does not sell or recommend annuities, but we are happy to evaluate options for our clients who hold them. For those who don’t, we have better ideas.
Now let’s look at April market results.
APRIL 2017 INDEX REVIEW
The S&P 500 posted a 0.91% gain (1.03% with dividends) and was up 6.49% YTD (7.16%), with a one-year return of 15.44% (17.92%). Since the November 8, 2016 election, the index is up 11.43% (12.49% with dividends), with 21 new closing highs, 13 of them in 2017 but none in April.
S&P MidCap 400
The S&P MidCap 400 added 0.76% after its March decline of -0.56%, trailing the other headline indices. The sector was up 4.35% YTD, with a one-year return totaling 18.56%.
S&P SmallCap 600
The S&P SmallCap 600 gained 0.85% after March’s 0.27% decline. Year-to-date, the S&P SmallCap 600 trailed the other indices, with a 1.60% gain compared to 6.49% for large caps. Over the one-year period, however, the group still led, with a 22.38% gain compared with 15.44% for large caps.
For the month, Global markets gained 1.46%, as 35 of the 47 markets moved up. The gain came as the US continued to underperform following the strong post-election gain that lasted through the end of 2016. For April, the US posted a 0.94% gain, while the ex-US global gain was 2.02%. Year-to-date, global markets were up 7.86%; excluding the US gain of 6.28%, they were up 9.67%. Over time, however, the US still outperformed, with its gain since the November 8, 2016 election at 12.08%; global markets were at 11.06% with the US, and 9.97% without it.
Emerging markets continued to do better than developed markets, posting a 2.08% gain for April after a 1.93% March advance. Fourteen of the 22 markets showed gains, compared to 15 markets that advanced in March. Year-to-date, emerging markets gained 13.04%, bringing their one-year gain to 16.61%.
Interest rates decreased in April as the expected speed of US interest rate increases slowed, while global rates were seen as holding near their lows. The 10-year US Treasury Bond closed at 2.28%, down from last month’s 2.39%, and 2016’s year-end 2.45%. The 30-year US Treasury Bond closed at 2.95%, down from last month’s 3.01% and 2016’s year-end 3.07%.