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Playing it Safe With Annuities

Playing it Safe With Annuities

Often criticized for their high fees and their complexities, annuities are drawing renewed interest from investors who want security in the wake of the recent financial collapse.

The last time investors took to annuities in a big way, FDR was president and one out of every four Americans was out of a job. Not surprisingly, the widespread uncertainty engendered by The Great Depression bolstered public interest in contracts that would guarantee income to their buyers. In 1930, annuity premiums totaled $108 million, according to insurance consultant Advantage Compendium Ltd.; nine years later the figure had nearly quadrupled. It's tempting to draw parallels between then and now, as today's investors survey the damage done to their portfolios in the financial collapse and as national unemployment nears 10 percent. But will retirees and those closing in on that milestone embrace these products as their parents and grandparents did so many decades ago? After all, annuities aren't right for everyone.

So far, the answer to that question seems decidedly mixed. Sales of fixed and variable annuities actually fell last year by 11 percent, to $234.9 billion, according to industry researcher LIMRA. But the slide in sales may not reflect consumer dissatisfaction with the product in principle, some industry experts say. Mid-decade, an arms race for variable annuity market share led some insurers to cut prices and add attractive features; this provided incentives for holders of existing annuities to trade up to better policies. But as asset markets worsened in late 2008 and 2009, some insurance providers dropped offerings, while others began marketing products with scaled-back features and higher fees. Rather than trade down to new policies, consumers kept the ones they already owned, say analysts.

Mid-decade, it was “overwhelming that you should have a piece of the investment plan in a variable annuity for someone entering retirement because of all the benefits you received for that price,” says Mark Thompson, chief partner at Thompson Wealth Management, a Raymond James & Associates practice in Melbourne, Fla. These benefits, like guaranteed upsides on the principal, have gotten a lot more expensive today. “Now you really have to look at the numbers, and in most instances we're not finding it as attractive for the client as we did a year and a half ago.” He estimates his own sales of variable annuities to clients are down at least 60 percent since mid 2008.

But as the public re-evaluates the investment market and seeks greater investment security after the collapse, annuities may be getting a fresh look. In February, President Obama's Middle Class Task Force issued a report calling for the promotion of annuities and other forms of guaranteed income so that retirees won't run the risk of outliving their savings. And many financial advisors say they're hearing from shell-shocked clients who are more interested in preserving what's left of their portfolios than in maximizing gains from the equity market. “I've noticed more people being scared than ever before in my career, and I started in 1996,” says Cass Chappell, a certified financial planner at Chappell, Mayfield & Associates in Atlanta, Ga.

“When the Internet bubble burst, people were scared, but it was a different kind of scared. Now you have the whole Tea Party movement and the idea that health care [legislation] is going to somehow take away Medicare and really put these people who are past their earning years in some kind of jeopardy. They really want to get this whole risk off their plate and get it on somebody else's plate. I think there's a lot of people who have been changed forever that are in this demographic of ‘over 60,’ changed at the core by what has happened in the last couple years.” And that kind of fear is resulting in greater interest in guarantees — guaranteed principal, guaranteed income, in other words, annuities.

After all, faith in the old reigning market philosophies has been severely shaken, says David Blaydes, a certified financial planner and president of Retirement Planners International of Naperville, Ill. Those who believed in buy-and-hold watched index benchmarks fall to 10-year lows during the financial crisis, he says. Modern Portfolio Theory — the idea that diversification of assets among stocks, bonds and other non-correlated assets will maximize portfolio gains while protecting against losses — also failed in the last market downturn, as nearly all asset prices tumbled simultaneously. “This past decade has not been a typical decade. We invest today almost from a position of paranoia,” Blaydes says. Clients tell him, “I don't want to go through this again. I'm getting close to retirement.”

Pros and Cons

Of course, annuities aren't necessarily appropriate just because an investor is apprehensive about the alternatives. The product has a bad reputation in some circles. The industry is rife with stories of complex annuity products being peddled to investors in their 80s who wouldn't have stood to benefit, and who often didn't understand what they were buying in the first place.

Because annuities tend to have many moving parts, advisors need to study the products carefully before recommending them to clients. Immediate annuities provide a stream of payments that begin upon purchase, and are usually bought when retirement commences. Variable annuities are so-named because their underlying value is linked to investment options, usually mutual funds, whose own value rises and falls. They can be bought years before retirement, with the payout period starting at an agreed point in the future; the payout is usually a percentage of the value of the investment. Variables offer tax-deferred growth provided the withdrawal period doesn't start before age 59 ½; it's a feature that retirees in lower income brackets may have less use for, some advisors say. Equity indexed annuities are a kind of variable annuity whose value is linked to an index such as the S&P 500.

And then there are complex riders that dictate the size and timing of income payouts, death benefits to beneficiaries, and other policy terms. All riders come with fees that can boost the total cost of the policy quickly, and some of these fees have risen sharply in the past two years. Chappell has seen living benefit riders, which can guarantee payout sizes regardless of the value of the underlying investment, go from 0.60 percent to 0.85 percent. If a policy holder wants to back out of the deal within a proscribed period of time, there are surrender fees that can run several percentage points of the policy's value. Morningstar estimates that total average expenses for a typical variable annuity policy ran 2.51 percent of the principal in the fourth quarter of last year. But Thompson has seen some policies whose fees run 3.25 percent, “and that's a substantial amount for the rest of your life.” To help prevent abuses, the National Association of Insurance Commissioners recommended in March that states adopt new rules that would hold insurers responsible for ensuring that their annuities are client-appropriate, even when a third-party salesperson completes the deal. But these recommendations are, at a minimum, months away from being adopted.

Ron A. Rhoades, private wealth manager and director of research at Joseph Capital Management in Hernando, Fla., suggests immediate annuities are best for people of modest means who might run out of cash in retirement. It can make sense to buy a lifetime annuity, and perhaps a second policy years later if a retiree's income needs to increase and if annuity returns are suitable. But he says the product doesn't offer a good return in the current low-interest rate environment, and suggests investors wait until interest rates pop back up to around 5 percent.

Equity index annuities tend to be expensive, says Rhoades, and can provide insurers with more control over policy terms than he's comfortable with. Some allow insurers to lower the payout cap, limiting the upside growth on living benefit riders. Another factor to consider when evaluating equity-indexed annuities is the underlying benchmark. The S&P 500 is a price-only index that excludes the effect of dividends; such payouts contribute more than 2 percent to the total return of the index, Rhoades says. “That's a pretty big haircut right off the top.” Stocks make more sense to him in mutual fund products than in annuities, since mutual funds let investors harvest losses when they occur, or provide them with the opportunity to time when they choose to take capital gains.

Advisors can agree that annuities are unwise for the very young and the very old. But they also agree that annuities can be useful for those nearing or starting retirement — depending, of course, on the cost, the riders and the individual investor's needs. Blaydes doesn't recommend that anyone who's planning for retirement get into an annuity until they're at least 50 years or older; younger people get a better long-term return with a diversified portfolio at lower cost, he says. Since annuities are tax-deferred, investors cannot withdraw their money before the age of 59 ½ without paying a 10 percent penalty, rules that also apply to IRAs and 401(k) plans. Blaydes likes to put investors' money in more than one insurer's annuity at a time, a form of diversification in case one of the companies fails. He also likes to keep about 30 to 35 percent of a retiree's portfolio in non-annuity products such as lower-cost mutual funds whose growth could provide some protection against inflation.

Product Landscape

Some insurers who have been hit with lower annuity sales are responding with changes in their product offerings. ING Group saw new variable annuity sales last year fall by nearly 63 percent. Now its ING Financial Solutions unit is offering a simplified, low-cost annuity as part of a suite of products that include new versions of its fixed and indexed annuities, and a new mutual fund-based IRA. About 20 percent of financial advisors account for about 80 percent of annuity sales, says Lynne Ford, chief executive at ING Financial Solutions. ING's hope is that a simpler product will be more appealing to a broader segment of financial advisors who don't have the time to explore all the ins and outs of the more complex annuity products out there. The annuity can be a compelling product for retirees when you consider that the average 65-year-old has a 50-50 chance of living to age 92, and possibly outliving his money, Ford says. That's what the guarantees are for.

“More and more advisors who historically would have been in the I-don't-sell-annuities column are raising their heads and saying, ‘Wait a minute. The customer's sitting in front of me and they're getting ready to retire, and I need to offer them something more than a bond fund or dividend-paying stocks or a laddered bond portfolio. If I just go with one of those strategies, I can't show them a probability of success that they're going to be comfortable with,’” Ford says. “Advice is still going to be critical. Americans are on their own. They don't have pensions anymore. They're going to have a small Social Security check and a pot of money. So they're going to need advice regardless of how small or large that nest egg is on how to insure that they will not outlive their money.”

Rob Fritz, vice president of investments at Thompson Wealth Management, thinks it's “crazy” that investors don't look at the income guarantees of annuities in a larger context. “People are willing to insure cars and homes and absolutely refuse to leave the house without all that protection,” he says. “But sometimes their assets in their 401(k)s or IRAs are multiples above the smaller assets they insure like clockwork. And those [smaller] assets don't fluctuate, usually. You don't get hit by lightning and your house doesn't burn down that often. But we do see 15, 20, 30 percent corrections in the market on occasions that can devastate people.”

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