The Annuity Conundrum

Many advisors, like Ken Fisher, make their living by bashing annuities. I too have had some harsh words for annuities, and still often do. They are often over-priced, and some even seem deliberately designed to confuse. Annuities also have some nasty tax consequences, especially for the very wealthy. But annuities can do things that no other investment product can do: Provide income in the absence of principal. This can be super-important for a retiree with limited savings. This can embolden risk taking inside the annuity or with other investments that could be the solution to decent returns. Otherwise, a poorly funded retirement can get relegated to only "safe" investments with limited returns simply because the lumpiness of risky returns can increase the odds of running out of money before one runs out of life.

But annuities also have a darker side. Not only are the fees often very high, but the fees are also calculated in "creative" ways. The devil is in the details. I was recently asked to review an investor's annuity they had purchased in 2007 from a recognizable "name brand" insurance company. What I found was a little bothersome. The variable annuity was invested in stock mutual funds, but eight years later the account value was basically flat. That's odd, even given the 2008 meltdown. Despite the underlying investments actually providing returns of nearly 50% in aggregate, the account had lost nearly 40% of its potential value to fees, and thus barely moved the needle on current cash value.

Some annuities with "Living Benefit Riders" offer a feature that compounds a phantom future income benefit in years that no income is withdrawn. In this case, the account features a "guaranteed 6.5% annual increase". But don't for a minute think the annuity guarantees a 6.5% return. It only guarantees that your income in the future will rise by 6.5%, and it only does that in years you take no distributions. They do this by creating a "hypothetical principal value" which does compound at 6.5%. Seeing tens thousands of additional phantom dollars on a statement lends acceptance to the concept as valid. Yet, that value cannot be liquidated or distributed. Only the cash value can be liquidated and only the "income benefit" can be distributed in small bites over time. But wouldn't you know it, most of the fees charged against the account are calculated against the hypothetical value, but deducted from the cash value. So the steadily increasing "income benefit amount", which has no real cash value and is not available to be distributed is what drives the fee calculation? So they take your "real" money, and give you back "hypothetical future money"? Yep. While it would appear on the surface that the fees are 3% or so annually, they are actually over 5% annually. That's because a $100,000 original investment has barely budged in value while getting dinged for over $5000 per year in fees. But the "income benefit" is now nearly $200,000 and that is the value used for many of the fee calculations.

It's easy to see the trap developing, where an investor believes they can't afford to "leave" because they are eight years into it, have too little principal remaining and too much "income benefit" accrued. You think the insurance company could see that coming? This accounting tends to create the illusion of vast additional value, and it may have some value. But is it worth the cost, and is it as good as we perceive it to be? In many cases, no. I believe the cheapest versions of these products are often worth the cost in certain circumstances, but the cheapest annuities offer little to no commission for an agent, so don't expect to hear much about those. These cheaper products also often don't offer the gimmicky compounding feature which contributes greatly to costs and confusion over time.

My firm is not licensed to sell insurance products, or receive a commission from such. We simply offer advice on how these and other products work so investors can make better decisions.

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