By Ken Waltzer, M.D.
Recently, I attended a presentation sponsored by the CFA (Chartered Financial Analyst) Society of Los Angeles. Most of the attendees were professional investors and wealth managers. The topic was annuities, but the presentation wasn't about how to analyze these often-complex investments. Instead, the speaker focused on how consumers evaluate annuities.
I'm used to hearing from fellow investment professionals that annuities are overpriced and often unnecessary, and thus I wasn't shocked to learn that most of the people in the room were skeptical of annuities. But I was surprised to learn that consumers and wealth management clients also dislike annuities, perhaps even more than professionals. On top of this, they are very poor at comparing the value of different annuity products.
Negative bias combined with poor analytical skills means that annuities are often a difficult sell, even when they might be useful. This may result in clients avoiding annuities even when they might be appropriate -- sometimes to the detriment of their retirement. And those that do buy annuities often end up with the wrong one for them. For these people, the realization that they've been sold something inappropriate further reinforces their bias against annuities.
Let's take a closer look at annuities and try to understand what they're used for. We'll then look at how to decide when one might be a useful addition to your retirement investment portfolio.
What is an annuity? At its core, an annuity is simply a series of cash payments paid over a term of years or a lifetime. That's it. Everything else is decoration. What makes annuities so confusing is that the products sold by insurance companies, which represent the bulk of the market, come with all sorts of fancy wrappers and high-fructose fillers.
We can divide insurance company annuities into two basic flavors:
Fixed annuities take in a lump sum of cash and pay out a predetermined amount (sometimes indexed for inflation) over time. Fixed annuities can be immediate, starting payments right after the cash is deposited, or deferred, allowing the lump sum to grow for some time before starting the payout.
Fixed annuities are also available through many non-profit organizations in the form of charitable gift annuities (CGAs). The difference is that the payout is less generous than those from insurance companies, but money left over at the end goes to the charity and not to an insurance company, and they also have a tax deduction feature. While they have their place, CGAs are more of a donation than a retirement investment and are outside the scope of this article.
Variable annuities: If fixed annuities are plain vanilla, variable annuities are jamoca almond fudge. They are often complex, confusing, expensive and unnecessary (but not fattening). And they are very profitable for insurance companies, which is why they represent the bulk of annuities sold. Variable annuities have two phases: the accumulation phase and the distribution phase.
In the accumulation phase, money is added to the annuity and that money (hopefully) grows over time. During the distribution (or annuitization) phase, you receive monthly payments as with a fixed annuity. In some cases, you can keep the annuity untouched until it passes to your heirs.
What puts the "variable" in these annuities is that rather than receiving a fixed interest rate guaranteed by the insurance company, your money is invested in a selection of mutual-fund-like investment accounts that typically include stocks and bonds. Thus, while the return is usually higher than that of a fixed annuity, it isn't guaranteed and varies over time.
Fixed annuities tend to be very low cost (to go with their low return), while variable annuities tend to have high fees and often surrender charges if you want to cash out early. It's not uncommon to find variable annuities with annual costs exceeding 3% per year, plus surrender charges of 10% or more.
Many variable annuities offer add-on riders, such as "living benefits" that guarantee a minimum monthly payment during the annuitization phase. Or maybe the agent wants to sell you an "equity-indexed annuity," whose return is tied to an equity index by an exceedingly complex formula. Not surprisingly, these riders and features come with additional fees. And along with higher fees come higher commissions for the annuity salespeople.
Variable Annuities in Retirement? No So Fast
Do variable annuities have a role in retirement planning? Yes, but it's narrow one, in my opinion. They offer tax deferral of income, but during annuitization or when making lump-sum withdrawals all profits are taxed as ordinary income at your marginal tax rate. Given that much of the earnings tend to come as dividends and capital gains, which are taxed at reduced rates, the benefits of tax deferral can be offset by higher tax rates at withdrawal.
If you are in a high tax bracket and have maxed out your tax-deferred retirement plans, a variable annuity may make sense. But the analysis can be complex, and best done in consultation with an experienced financial planner. Seek out products that feature lower fees and -- unless you really need them -- avoid expensive riders such as living benefits.
So now you know why both advisers and clients tend to be biased against annuities: they have been bombarded by confusing and expensive variable annuities pushed by everyone from insurance agents to local bankers. In the meantime, fixed annuities are mostly ignored.
Fixed Annuities: The Price of Certainty
But low-return, boring fixed annuities may have a place in your retirement plan. This is because they can reduce one of the biggest risks of retirement: longevity risk, or the possibility that you'll outlive your money. A life annuity will send you the promised monthly payment right up to your last breath, even if you live to 110 (provided the insurance company stays solvent: make sure you buy only from highly-rated companies). The knowledge that this monthly income will never stop also provides peace of mind.
In short, the main benefit of a fixed annuity is guaranteed lifetime income. (By the way, all of us already have at least one fixed annuity: Social Security. This program provides guaranteed lifetime income, and it's inflation adjusted.)
But what must you give up in exchange for this guarantee?
First, fixed annuity rates of return tend to be low, considerably less than the average annual return of a balanced 60% equity/40% bond portfolio. In fact, their returns tend to be below even that of a 100% bond portfolio. Of course, portfolio returns are not guaranteed.
Second, a fixed annuity locks you into a static monthly return. Even with an inflation adjustment, if your expenses go up faster than the payments, you could be caught short. And if you need a larger sum for an unexpected expense or a discretionary purchase, you'll have to get the funds from somewhere other than the annuity. Once the payments start, your money is committed for posterity.
Third, you are betting the insurance company that you will live as long as your actuarial life expectancy. If you live longer, you receive a windfall. But if you die early, the insurance company keeps the rest of your investment; your heirs get nothing. Thus, fixed annuities make the most sense for those who think they will live longer than average.
Should You Buy a Fixed Annuity?
Now that we've reviewed the pros and cons of fixed annuities, we come to two key questions facing you as a retired investor:
Do you need one at all (on top of Social Security), and
If so, what percentage of your assets should you invest?
To address the first question, are your non-discretionary expenses in retirement (housing, transportation, food, healthcare, taxes, etc.) more than your Social Security income? If they are not, an annuity is superfluous. If they are, it may make sense to fill some or all of this gap with a fixed annuity.
How much of the gap should you fill? Your initial response may be, "All of it." But remember, every dollar you put in a fixed annuity is one less dollar for your heirs. Plus, your total wealth will likely be reduced because of the lower guaranteed return of annuities compared with most non-guaranteed investments. And you will lose the flexibility to spend the amount committed to the annuity as a lump sum should the need arise.
As will all investments, fixed annuities present a tradeoff: guaranteed income you cannot outlive in place of probably greater income and/or assets that you can enjoy or gift as you please. In short, ask yourself, "What price certainty?"
There is a quantitative way to estimate how much to put into an annuity. Using Monte Carlo simulation of retirement scenarios, you can try different amounts, say 25%, 50% and 75% of your non-discretionary spending shortfall, and see which produces the highest "success rate." While your total wealth will likely decrease, adding an annuity might reduce the chance of failure, meaning running out of money too soon. Your financial planner should be able to run these scenarios for you.
Note that if you have barely enough money to make it through retirement, an annuity could make things worse by reducing the total amount you can spend. Conversely, if you have way more in assets than you need, an annuity is not likely to increase an already sky-high success rate. Thus, a retirement annuity makes the most sense for people who are between these extremes.
To sum up, a variable annuity provides tax-deferral and can provide guaranteed lifetime income, often at considerable cost. A fixed annuity provides guaranteed lifetime income at low cost, but at the expense of total wealth, flexibility and the size of your legacy. Only you can decide what works best for your situation.
About the author: Ken Waltzer, M.D., MPH, AIF®, CFA, CFP® is co-founder and managing director of KCS Wealth Advisory, LLC, a registered investment adviser based in Los Angeles with over $200 million in assets under management. He has worked full-time as a wealth manager since 2004, having previously been a practicing physician and medical entrepreneur. He started studying finance and investing for his own account in 1975 and has managed other people's money since 1997. Ken realizes that investing, like medicine, is both science and art. He combines the latest in capital markets theory with behavioral finance, informed by the insight and intuition that comes from 40-plus years of active investing. As in the doctor-patient relationship, he aims to help each client understand his or her financial prescription and stay on track toward a healthy financial future.