Ask These Key Questions About Annuities
Question: You brought some data showing that consumers really don't understand annuities. In fact, one statistic you had was that 44% of consumers rate themselves either a D or an F in terms of their knowledge of annuities. So, people really are oftentimes baffled by these products. They are complicated; it can really be difficult to know what you own or how to purchase one or even what questions to ask.
There are key questions to ask if you are talking to an advisor who is encouraging you to buy an annuity product. Maybe we can run through some of the ways that you might be a savvy consumer.
Let's start with a big one, which is, what is the benefit of this product versus just a vanilla portfolio that doesn't include any insurance protection?
The number one concern for people three to five years from retiring is running out of money during their retirement. And for most people with a diversified portfolio, that's not going to be a problem. But for some percentage of them, depending on the timing of when they started taking their withdrawals and what their allocation is, there might be an 8%, 10%, 12%, or 15% chance of running out of money during retirement.
What you can do is pool that risk. By transferring risk, which is what annuities do, you are pooling that risk, so if you are the unlucky one that might be in that 8%, 10%, 12%, or 15% band, this protects you from not having a paycheck during your lifetime. Think about it like your homeowners insurance. We all chip in our $800 or $1,000 a year into the pot. For most people, it's a terrible investment. They're going to get zero return on that. But I live in New Jersey, and when Superstorm Sandy hit, it was the best investment that many people had ever made in their lives because houses were wiped out.
When you're transferring risk, and you're using insurance, you do that on things that aren't likely events to occur, but that if they occur, are financially devastating. If they're likely to happen, it's too expensive to insure, and it has to have a big impact on you--which running out of money during your retirement does. So, annuities transfer that longevity risk, that income risk.
We are paying an extra fee, and there could be additional complexity with it, but it's a trade-off. And it's something we hope you're never going to use, and it's also not likely that you are going to use it. But if you retired in 2000 right at the beginning of a downturn and were withdrawing from your portfolio with a broad basket of stocks, right now you are almost already out of money. So, those are the things that we're trying to protect people from, and you pool that risk. That's where we think it fits.
Does everyone need a product like this with guarantees?
What types of people can say, "No, I don't need that type of protection?"
The annuity does a couple of things. It can provide you with enough to cover your "needs" expenses, and then you can invest the rest in lower-cost investments to complement that for your "wants." But at least you know that your basic expenses are covered. If, between pension, Social Security, and some type of guaranteed paycheck, my needs are covered, then I can sleep at night, and if I don't get to take a vacation this year because the market was down, I can live with that. If I can't pay my property tax or buy food, that's something that becomes difficult. Sometimes in pursuit of someone's wants, they sacrifice securing their needs. This is where annuities can fit in.
For somebody who has a very low withdrawal rate and can assume the risk of the market or can hedge this in some other way, [an annuity is] not necessary. If your house got destroyed and you have enough resources to rebuild it without having a big impact, maybe you don't need homeowners insurance.
So, it's something that you have to look at: What's the probability of this happening? What's the downside if it happens? And do I have options to be able to absorb that? It's like any other insurance decision.
Another key question is the cost of this thing. Annuities have many layers of costs that can be really difficult to get your arms around. If consumers are trying to be smart about this, what are the best data points that they want to look at to try to get their arms around the all-in costs of owning an annuity?
If you're owning a variable annuity with an income guarantee, which is where most of the new investments in these are are going because it does provide this unique protection, it has upside tied to the equity markets, and it has a level of protection that sits below it.
But the costs on it are going to be the internal costs. The mortality and expense charge is what the technical internal costs are. That's how the insurance company makes their money, and it's how the advisor is getting paid.
Then there's the cost of the underlying investments that you're in--the subaccounts. So they could be indexes and very low-cost; they could be active managers with a little bit higher cost. And they're trying to outperform the market.
Then there's going to be the cost for the protection, and that rider fee is typically a separate cost. Most of the time, it's assessed against the guaranteed amount. They are charging the insurance cost against the number that they're insuring. So if your guarantee has some type of growth rate on it, that cost is going to be increasing. Understanding what those internal costs are and how they are being assessed--if they're assessed against the account value as a percentage or against the guarantee as a percentage--can also have an impact on the drag on the portfolio.
But if you owned a house for 30 years, and you didn't have homeowners insurance, you would have a higher rate of return on that real estate. If you never had a fire or flood, that was a smart move. So it is a cost, and you are getting protection for it. You've got to weigh whether the value of that protection is worth the cost.
You note that another question people should ask when evaluating some sort of an annuity product is, what sort of supplemental protection does it provide? Can you go into detail about this, and what are people looking for when they're trying to evaluate that?
The two most common would be some type of income guarantee and some type of death benefit.
The income guarantee is something that provides you, or perhaps you and your spouse, protection of income for the rest of your life. An example might be that you invest a set dollar amount and you can invest in the equity markets, but they will guarantee you 5% a year for life off of that value.
So even if the market gets hit and you're drawing from it and the account runs out of money, and one of you lives to 100, if you ran out of money at age 80, they keep paying you this $5,000 a year for 20 more years. That's the additional cost that everyone is paying, it's to pay that person who ran out of money--that $5,000 a year is coming from somewhere. It's from that pot that everybody is chipping into.
If your account value does well--your $100,000 goes to $120,000 and then $130,000 and then $150,000 during the next five years--some annuity providers will reset that guarantee, and now you're getting 5% of $150,000. And if the market has a big downturn again, it drops below where you originally started--it goes from $150,000 all the way back down to $90,000--you keep getting 5% a year for life off of that high anniversary value hit in year 5, and it becomes a permanent raise.
It's has equity feel and exposure to it, but the protection is dynamic. If I owned a mutual fund that went from $100,000 to $150,000 and now back down to $90,000, I've got a $10,000 loss and a lot of remorse for not getting out at $150,000.
You've actually captured some economic value by that account hitting that peak at some point that changes your cash flow for the rest of your life. So, there are some really unique things about this that nothing else can replicate, and obviously that's a big difference for the insurance company. There is going to be a cost for them to assume that risk.
The spousal protection carries a cost, too, right? You can't just add that without paying more?
Well, it's interesting. On some of the legacy contracts, spousal protection was baked into it, and it was something that the issuers were just able to continue. So, many of the contracts issued before 2009 have this spousal continuation as a default, and it wasn't additional.
For the newer contracts, it was an option that people had to choose, and it was either single life or joint life. These contracts will do one of two things--either charge more for the joint or it may be a lower withdrawal rate. If it's 5% for a single, it might be 4.5% for a joint, and it's the same cost.
The insurance companies have different levers they can pull with this. They can modify what you can invest in, they can modify cost, and they can modify the withdrawal rates. Those are all levers.
Comparing and contrasting these does get a bit complicated, and what we tend to find is someone is presented one product. Somebody might know that one well, they might work for that company, and that's the solution. But I really think it's something that you should shop out. Ask other people. Get an independent analysis because it can be a significant difference.
You've hinted, Mark, that incentives can skew the decision-making. The person presenting you with this product may have a vested interest in getting you to choose the more expensive one. How can you direct the outcome so that you are in fact being shown the full suite of products rather than just the one that pays the salesperson the best?
I think you can ask that question. You can ask them to provide you an answer of that in writing. One of the other things that you can do is talk to more than one person.