I love the idea of annuities. Wouldn’t it be wonderful if retirees could simply get ‘minimum returns’ or ‘guaranteed withdrawals’ from their money and take all of the risks out of investing? After all, investing can be scary and ‘participating in the upside of the market’ while ‘guaranteeing your return’ sounds like every investor's dream. Unfortunately, the idea of annuities and actual annuities are very different things and actual annuities often fall far short of the promises that they offer in sales literature. Time and time again I like what I hear in the ‘sales pitch’ but then am gravely disappointed when I actually dig into the contract and run the numbers. The problem, of course, is that annuities are complex investment vehicles that have high costs, complex restrictions, and other risks that offset the benefits of the ‘guarantees’ they offer. In fact, while annuities may not seem risky at first, they may not be the best way to manage your risk in retirement and may actually damage your ability to reach your retirement goals.
Simply put, annuities are contracts between you and an insurance company to provide a stream of income in the future. Since annuities are contracts, they can be written in hundreds of ways and therefore, generalities are difficult to make. There are immediate annuities and deferred annuities, fixed annuities and variable annuities, index annuities and fixed indexed annuities, and on and on it goes. And yet, through all of the confusing landscape of annuities, there is one significant issue that is common to almost all of them – high costs. That is what we will focus on for this article.
Remember that annuities are insurance products and there is a cost to the ‘guarantees’ that are offered. Likewise, any additional ‘features’ or ‘riders’ of an annuity all come with a price tag attached. In order to appropriately evaluate whether the costs are worth the benefit you first must understand the costs. Would you like fries with that? Of course, but not if the fries cost me $100! Unfortunately, the cost of the annuity often gets lost in the complexity of the contract. There is rarely one place where you can see all of the charges in an annuity so read carefully! Since we can’t look at all annuities, allow me to provide an example from one of the most popular products, variable annuities. The table below details common costs in variable annuities:
COMMON EXPENSES EMBEDDED IN VARIABLE ANNUITIES
Variable Annuity Expense
Hypothetical Annual Cost for $100,000
Optional Guaranteed Minimum Death Benefit Rider0.61%($610)
Optional Guaranteed Lifetime Withdrawal Benefit Rider1.03%($1,030)
Fund Expenses for Underlying Funds in Variable Annuity0.94%($940)
Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38, 56, Fisher Investments.
In practice, the above costs are taken from returns each year. Therefore, an investor may ‘participate in the upside’ of the market but carry an almost 4% expense along the way. Consider, for a moment, the impact of $100,000 invested in low-cost funds earning 6% on average vs $100,000 invested in an annuity with the same before-fee returns, but with the drag of 4% fees. Over a 20 year period, the value of the low-cost mutual funds would be twice that of the value of the annuity. Yes, the contract may include other payout provisions, but these costs do matter.
So what about the benefit? Variable annuities often offer a ‘guarantee’ that would pay out if the market crashes. Is the guarantee worth it? Every situation is different and here investors must consider their own unique circumstances. However, allow me to provide a reference point to analyze the value of the insurance in an annuity. Most annuities require a lockup period of 10 years, and the worst 10-year rolling return on the S&P 500 was -5.4%. Surprised? The stock market can be extremely volatile in individual days, months and years, but over the long term, it does still tend to go up. During that same 10-year lock-up period, an investor in a variable annuity with 4% annual fees would pay 40% in fees. For the overwhelming majority of investors, this type of trade-off just doesn’t make sense.
For most investors, a better way to manage risk is through the use of a properly constructed diversified portfolio. Diversification can help provide long-term returns needed to fund retirement while dampening the drops that investors fear. In contrast, the long-term impact of high fees in some annuities can be devastating and result in insufficient returns to fund retirement needs. Yes, everyone’s situation is different and this has been a simplistic view of complex instruments, but too often the fundamental issue of fees gets lost in the complexity of the products that insurance companies offer. If you are shopping for annuities, read carefully. Better still, give us a call to discuss your specific situation to see what strategies would work best for you.
For more resources on annuities check out Variable Annuities: What You Should Know.