ANNUITIES AS POOR INVESTMENTS
Why in the world would an insurance company be willing to pay commissions to get people to annuitize any of the annuity buildups? (Only about 1%- 3% of annuities are annuitized.) Because they'll make more money, that's why.
What you clearly need to recognize is that many annuity payouts provide extremely poor returns to the annuitant (you). Obviously, they therefore provide good returns for the insurance company.
Unfortunately, the basics of an annuity are usually totally lost on not only purchasers of an annuity, but the salespeople as well. And since I am an instructor in annuities to life insurance agents, let me tell you what I teach them.
The first thing about annuities- on the plus side- is that all the money invested can grow tax deferred until they are removed. And with qualified plans, the initial investment may be deducted from gross income- thereby also reducing current income tax.
Unfortunately, once you want to get the money out, there are several negatives. First- anything that has not been taxed (appreciation, dividends and interest) will be taxed as ordinary income. Almost universally, that will be higher than the long term capital gains tax. In fact, if you are in the highest ordinary income tax bracket, your income tax can be twice that that would have been occurred under capital gains. (See full text on annuities for more complete detail including surrender charges, bonus interest, etc.)
Next is the fact that annuities receive no step up in basis at the date of death. If you had invested $25,000 in a standard mutual fund and it grew to $100,000 and you died, your beneficiaries would receive $100,000 with NO tax (estate taxes not considered). If your beneficiaries had received a qualified annuity of $100,000, the entire amount would be taxed as ordinary income. Assuming a 35% total federal and state tax rate , they would send a check to the IRS for $35,000 and net just $65,000. Quite a difference. You MUST understand basis in order to do effective investment, retirement or estate planning.)
But the issues we are exploring are more complex. If an annuitant decides to annuitize, they may do so under several methods. It could be a singular lifetime, with a spouse or friend and cover for both lifetimes, for a set period of time (10 or 15 years for example), refund to a survivor if the annuitant should die prematurely, etc. (Also note that almost all variable annuities revert to fixed annuities during payout.) The kicker is how to figure out what the returns actually are under each method when presented to you by the insurance company. For that you must utilize a financial calculator. If you do not have one, your agent must have one and be conversant in its use. (If they don't have one, you got big problems since they were- and are- clearly lacking in the ability in how money works and are simply poor agents.) But assuming such capabilities exist, you utilize a basic present value calculation. You will know how much you have in the annuity (principal) and how much the insurance company is willing to pay under each payout option. But what you are lacking is how long the payouts will exist. That's because you don't know how long you will live (combined lives or whatever). WRONG! The annuity company is using an actuarial lifetime table based on its experience (though not necessarily utilized-see comments on elderly 86 year old annuitant below). They have statistical evidence showing how long you will be EXPECTED to live. So that's the time frame (in years) that you use for the calculation. But wait you say, you don't know what the company is using for their life expectancy. True. And even if you did ask, they universally won't tell you. But what you do have is the standard tables in use by the government. Here's one right here. Look at a man and woman age 65. Statistically how long does the man have to live? The answer is 15.2 years- till age 80.2. A woman can expect a lifetime of an additional 18.8 years to 83.8. Whatever your age when you annuitize, you can use this or a similar table to get a rough idea of the term in years the payments will be for.
Of course, many of you will say that you will live longer. O.K., let's get real. You're overweight, get no exercise and are glued to the TV. Further, and a major consideration, is your genealogy. Your father died of cancer at age 76 and your mother of a heart attack at age 79. Your only sister is sickly at age 61. While you would like to live forever, the odds are dramatically against you and you should figure for no longer than a standard lifetime- if that. (This is what I do, at least in a subjective mode, for each client I deal with. The anticipated lifetimes affect not only retirement planning (budget and net worth) but also investments (what type used and for how long), etc. and also many of the elements of estate planning since you need to figure on how much will be left in each estate- with a couple- at the first to die and the second to die or for anticipated beneficiaries. I tactfully acknowledge the truth and let them comment further on what they wish to do/how long they expect to live.) Here is a link that uses slightly different actuarial lifetimes but has an input form about your life and lifestyle that will let you gauge how long you might have to live. You may be unpleasantly surprised. But foregoing this, if you did the calculations just for the standard time frames, you will almost universally find that the returns are terrible.
Here is real life example that I took from a longtime client, male, healthy, age 68 who was sent payout numbers for his annuity. He would have about 13.3 years to live. I simply used the HP12C to figure out the numbers. I will note that the annuity company first just asked him what type of an annuity payout he wanted WITHOUT providing any of the numbers. That was ludicrous and I told them he had to get them to at least give the numbers for each payout.
|Type of Annuity Payout||Annual Return over Standard Actuarial Lifetime or Annuity Certain||Time period for a 6% return in years|
|Installment Life Refund||1.47%||20|
|Life with 5 year Guarantee||2.45||18|
|Life with 10 year Guarantee||-3.48||19|
|Life with 15 year Guarantee||2.44||22|
|10 year Annuity Certain||5.49||N/A|
|15 year Annuity Certain||4.91||N/A|
Yes, different companies will have different payouts depending on their mortality tables, maturity dates on the bonds, anticipated movements in interest rates, and other factors.
As additional info on payouts and returns, a major insurer sent figures to me and these were received 10/24/97. I have used males and females, ages 65 and 75 for single life payouts and those for 10 years ONLY and 15 years guaranteed (and for life if still living.)
|Life Only Annual Return||Lifetime required for 6% Annual Return||10 Year Certain Annual Return||15 year Guaranteed and Life Annual Return|
|Male age 65 (15.3 years actuarial additional life expectancy)||2.32%||24.33 years to age 89.33||3.93%||2.81%|
|Male age 75 (9.4 additional years)||.29%||13.3 years to age 88.3||3.93||2.81%|
|Female age 65 (18.8 actuarial additional life expectancy)||2.93%||33 years to age 98||3.93%||-0.16%|
|Female age 75 (11.9 additional years)||1.82%||16.92 years to age 91.92||3.93%||2.25%|
You may try to make "sense" out of the numbers but I wouldn't bother. The simple fact is that one needs to live a long time in order to get a 6% annualized return. This makes many annuities unrealistic- at least in my work as a planner.
As a recent example of how little "sense" these actuarial tables might be, here is an October 1997 commentary from the Wall Street Journal. An elderly woman, age 86, was sold a variable annuity (that's absurd, ludicrous and wrong but commentary is addressed elsewhere in my site) and annuitized the product. Forgetting any implications for surrender charges and extraneous fees, the annuity company ANNUITIZED HER PAYMENTS AS THOUGH SHE WOULD LIVE TO AGE 106. In essence, they reduced her payments to an insignificant number by stretching the payments over an absurd length of time so they could retain more of the principal when she probably would die at around 91 or so. YOU OR YOUR ADVISER MUST KNOW HOW TO USE AN HP12C OR SIMILAR IF YOU ARE GOING TO USE ANNUITIES OR MOST OTHER INSURANCE OR INVESTMENT PRODUCTS.
Dispensing with the absurdity and fraudulent activity, there is an additional major negative aspect to annuitization that is rarely addressed. Before you say if you find any of these rates acceptable, you must also take into account that once the annuitization starts, YOU, AS OWNER, LOSE ALL ACCESS TO YOUR PRINCIPAL. If an emergency should arise, you cannot access the principal. As an additional caveat to retirement-YOU NEED A LOT MORE ACCESS TO MONEY AFTER YOU RETIRE THAN BEFORE SIMPLY BECAUSE "STUFF HAPPENS". There therefore is an element of additional risk in having large amounts of retirement assets that are inaccessible. This makes many annuities doubly unrealistic.
Getting back to the returns- the highest return available under a normal lifetime was in using the 10 year certain (payments for 10 years only) at 5.49%. (You could do the same or better without losing control of your money.) The other rates were relatively pathetic- but that 's exactly what the insurance companies do not want you to see. That's also the reason that they do not effectively care about your health when you annuitize- actually even when you originally buy the policy. (See also impaired annuities.) Since most people will live about the actuarial lifetime, they can pay low returns and get away with it since no one tells the consumers and the consumers rarely work with agents who use a financial calculator. Even so, in my experience, literally none of the agents I have taught so far were ever remotely aware of how long people were truly expected to live and had not even bothered with these types of calculations.
Is there a positive to annuities? Yes and a real life example proves the point. One client of mine- healthy female age 62 actually had both grandmothers live to 100+ and her mother moved into a retirement home (not a nursing home) at age 90. In such a case, we have an individual that might actually live far longer than the average person. She might earn a good return on her money from annuitization due to the potential long lifetime. But even then we have the real world that can cause serious problems. Regarding the healthy male above- he had an accident at home in February 1997 and died shortly thereafter. If he had selected a life payout, his return would have been poor and access none. And due to the accident, his effective return would have been very negative. So you ask- what annuity payout did we actually utilize? When they provided the numbers back for the payouts, one was, apparently, conveniently missing. Lump sum. So I asked the client to see if it was available. It was and that was what was selected. I might have had to address the tax issues save for the fact that whoever had him buy the annuity years before had him do so in an IRA- a tax deferred vehicle in a tax deferred account. Ludicrous and unconscionable.
Of course one would say you simply add a beneficiary and get the extra money over a longer period and a higher return. Not so since the insurance companies simply reduce the payments to reflect the longer actuarial lifetimes.
I must note another positive use of an annuity however. If you have someone that is a mindless spendthrift who would have spent the money frivolously if they had it as a lump sum, an annuity serves the situation well since they get payments over a period of time but no access to the principal. Better they only get monies in drips and drabs and not allow the principal to be squandered. Additionally, annuitization could be used for many people who are not spendthrifts per se but are so lacking in basic budget planning they they tend to spend the assets well before their actuarial lifetime. But that is just being stupid.
Here is another seldom mentioned problem for Blacks, Hispanics, etc. Now, most monies in annuities come from Caucasians. Nothing insidious- just a fact. But all annuitization (at least to my knowledge) is based on a group of people of ALL races. However, there is a disparity in the lifetimes of different races. See this separate actuarial lifetime form from the government. Well, look at this breakdown of the actuarial lifetimes of Blacks. Their actuarial lifetimes are SHORTER. As such, at least statistically, they should receive more money since it is paid out over a shorter time frame. But they and Hispanics, Indians etc. are thrown into the same grouping as the bulk of the Caucasians and therefore, if they live their standard lifetime, their returns are even SMALLER. Admittedly as one gets older, the disparity between lifetimes of all races becomes far less, but it nonetheless exists and needs to be objectively dealt with.
Of course, we could use that same tack with Asians- who statistically live longer than even Caucasians. They are getting extra payments due to their longer actuarial lifetimes. The point being that if you belong to a minority, consider whether an annuity is worthwhile based on the most relevant actuarial table you can get from the government. But still, don't forget the loss of access to your principal- a big negative if too much is utilized.
In summary, annuities do provide tax deferral but clearly at the expense of ordinary income tax at annuitization. Secondly, there is no step up in basis. But of greater concern is the effective poor payouts that translate into poor yields. One may have to live 5 to 10 years longer than actuarially standard in order to effectuate a return similar to riskless or relatively riskless investments. Lastly, the principal is no longer available for use during one of the most critical times of life where money may be needed.
As a result of such teachings, some agents have accused me of not "LIKING" annuities or agents. However, they have missed the point of research and numbers. There is no such thing as emotion in investing (though some would certainly disagree). I just do the numbers and whatever I come out with is simply what I use in determining the viability of most investments, timeframes, etc. for a client. Based on the above numbers- and where they have been reinforced by previous studies- I think that annuities have been SOLD incorrectly and do a great disservice to many consumers who will not live long enough to get a return comparable to risk free investment (Treasuries) or relatively risk free (Short term bond funds) and where they have lost access to their money.
As regards the apparent dislike for agents- it simply relates to competency. If one cannot use an HP calculator or similar, the agent is incompetent and nothing more than a salesperson. That is not the key to financial success. If you continue to use that salesperson, you are also incompetent.
Annuities (Insure.com 2000) "Class action lawsuits filed against four companies that sold tax-deferred annuities allege that they misrepresented the way variable annuities (VAs) can fund IRAs, 401(k) plans, and other types of retirement programs. This violates consumer antifraud laws.
Nationwide Financial Services, American United Life Insurance, American Express Financial Corp., and SunAmerica Inc. were named in the lawsuits filed by class action specialists Milberg Weiss Bershad Hynes & Lerach of New York. The lawsuits allege that the companies used deceptive methods to market and sell tax-deferred annuities to fund retirement plans, when in fact any qualified retirement plan is tax-deferred."
"Nearly 55 percent of the sales of VAs were to such plans in 1997, according to the Life Insurance Marketing Research Association. According to Morningstar, the average annual expense charged by a VA is 2.08 percent, not including loads and surrender charges."
Add in at least another 25% who didn't have a clue to what they were doing anyway and that equals 80% of variable annuities that probably should not have been sold. Millions upon millions of dollars of bad sales to thousands upon thousands of people who simply used someone they trusted without doing their homework.
Variable Annuity Warning: (SEC 2000)Obviously readers know of my disdain for such products. They CAN work, but the application is limited. Anyway, the SEC is posting its own warning. In part, it has comments about the annuities offering bonuses- "Higher expenses can outweigh the benefits" of a bonus, the agency says. It lists several ways, not always obvious, by which variable annuity companies take back the bonus payments, including higher penalties for withdrawals and extending the periods over which such penalties apply.
Additionally, "the agency notes that Individual Retirement Accounts and 401(k) retirement plans, which offer the same feature at no cost, "are often more advantageous than variable annuities."
"Reflecting concerns that sales representatives often do not tell potential customers all they need to know about variable annuities -- and certainly do not emphasize the drawbacks -- the S.E.C. document, "Variable Annuities: What You Should Know," reads like a sober antidote to a salesman's smooth patter. It is filled with cautionary passages clearly designed to make a potential buyer stop and think whether he or she really would want to put money into an investment that financially penalizes those who might need cash in less than six or seven years and charges for features, like a lifelong stream of payments after retirement, that are rarely used."
Do you really want to annuitize?: (Moshe A. Milevsky and Virginia R. Young 2002) Specifically, our main qualitative argument is that there is a real option akin to the corporate finance usage of the word embedded in the decision to annuitize. A life annuity can be viewed as a project with a positive net present value. However, quite distinct from a fixed-income bond or period certain annuity, once purchased, a life annuity can never be sold, reversed, or exchanged. Its purchase is final because of the evere moral hazard involved in trying to terminate a life-contingent claim.
By using reasonable capital market and actuarial parameters, we estimate that the real option to defer annuitization is quite valuable until the mid-70s or mid-80s. Of course, the precise values depend on ones gender, risk aversion, and subjective health assessment.