One of the biggest risks an investor faces is running out of money in retirement. In a seeming effort to reduce this risk, some investors choose annuities. They may be drawn to “guaranteed withdrawals” or “minimum returns” that claim to provide a retirement free from worry about investments.
But below the surface, annuities are complicated investment vehicles. Many insurance agents don’t even fully understand the product they are selling! So it's no surprise that many investors face unexpected fees, complex restrictions and other risks after purchasing their annuity. Moreover, annuities may fail to deliver the simple "safety" they so often promise.
Annuities can shield you from certain losses, but there might be better ways to limit your risk while still reaching your investment goals. Are annuities right for you? Here are some questions to get you started (click on questions to find answers):
Or you can continue reading to learn two important, evidence-based insights about annuity ownership.
Case Study 1: Expect Low Returns on Indexed-Annuities
Fixed Indexed annuities—also known as equity-indexed annuities or simply indexed annuities—are rapidly becoming the most popular annuity type.1 But many investors do not understand what they’re buying.
The name implies equity exposure or market participation. But careful inspection reveals that these are actually variable interest rate products. The interest rate is based on a stock market index (like the Dow Jones Industrial Average or S&P 500), but the contract does not hold stocks or mutual funds. In addition, various indexing options, rate caps, rate floors and participation rates can erode expected return.
Confused by these terms? We can help. Click here to speak with one of our team of investment professionals.
At AnnuityAssist.com, we believe it’s important for any investor considering an indexed annuity as part of a comprehensive financial plan to understand how today’s indexed annuity contracts might have performed in the past. So we ran a simulation to show you how different options compare. Our hypothetical indexed annuity returned between 2.3% and 7.3% annualized—lower than stocks’ long-term average and only sometimes higher than bonds’ long-term average.
Source: Global Financial Data 1926-2012 as of 2/5/2013, *1% floor, 8% cap, 100% participation rate
Let's talk about our methods. First, we chose a reasonable cap, floor and participation rate to the S&P 500 price index to create our hypothetical indexed annuity. Next, we sampled 1,044 rolling 120 month (10 year) periods from 1925 – 2012 using point-to-point indexing. Finally, we compared the results to the average 10-year return of US stocks and Treasuries over the same time periods.
On average, $1 invested in each would, after 10 years, have returned $4.01 in the S&P 500, $2.80 in intermediate term treasuries, and $2.65 in the hypothetical indexed annuity. Investors should make sure they have reasonable expectations if considering an equity-indexed annuity.
1Source: LIMRA, U.S. Individual Annuities (2012, 3rd quarter)
Was that useful? Enter your email address in the form on the right side of the page to get access to future annuity research.
Case Study 2: Variable Annuity Fees Can Stunt Growth By 27%
Variable annuities have long been the most common type of annuity sold, probably because they offer mutual fund investment options with insurance-related guarantees. But are they a good investment?
An often-overlooked detail in today’s variable annuities is the asset allocation restrictions. In order to reduce risk to the insurer, some contracts limit the amount of investment that can be made in equity subaccounts. Some may even require a minimum investment in money market funds, which are generally as safe as cash, so additional insurance on those assets shouldn’t be necessary.
But if the lifetime income still sounds more appealing than the growth opportunity elsewhere, we believe it’s still important to keep digging—to learn how these contracts have performed in the past and assess the real cost of their protection. To assist you, we ran a simulation that compared the growth of a hypothetical variable annuity to other investment options.
We simulated a variable annuity subaccount asset allocation of 70% equities (S&P 500) and 30% bonds (10-year US Government Bond Index). We used the industry average annuity total annual fee expense of 3.34% (1.18%2 for mortality and expense risk fee, 0.19%2 annual administrative fees, a 1.03%2 optional annual living benefit rider fee, and 0.94%2 average annual fees charged by the subaccount funds). (Not sure what this means? We can explain.)
Obviously the allocation restrictions make it difficult to keep up with an index like the S&P 500, but our results held that the high fees had an unexpectedly large impact on the overall growth of the hypothetical annuity. The variable annuity always had lower returns than the stock index for the same period. But it barely even beat the bond index on average, as seen below.
Source: Global Financial Data 1926-2012 as of 4/10/2013. These are estimates by GFD to calculate the values of the S&P Composite before 1971 and are not official values. GFD used data from the Cowles Commission and from S&P itself to calculate total returns for the S&P Composite using the S&P Composite Price Index and dividend yields through 1970, official monthly numbers from 1971 to 1987 and official daily data from 1988 on. *Assumes a hypothetical annuity invested in subaccount funds equivalent to the 70/30 blended index described below, less annual annuity expenses of 3.34%. **70% S&P 500/30% US 10-year Gov Bond Index. Performance is presented inclusive of dividends and interest.
Let’s talk about our methods. First, we assumed an investment equal to 70% of the equity index and 30% of the bond index rebalanced monthly to closely match the gross performance of a 70/30 benchmark, and paid the fees at the annual rates listed above. Next, we sampled 1,044 rolling 120-month (10 year) periods from 1925 – 2012. Finally, we compared the results over the same time periods to the average 10-year return of US stocks, Treasuries, and the same 70% equity 30% bond asset allocation without the headwind of annuity fees.
On average, $1 invested would, after 10 years, have returned $4.01 in the S&P 500, $2.80 in intermediate term treasuries, and $2.91 in the hypothetical variable annuity. Investors should consider whether the impact of variable annuity fees is worth the protection that they provide. And if there enough value in sacrificing potentially 27% of your potential growth (on average) for the anticipated stream of future payments when annuitized?
Variable annuity fees can take a much greater toll than expected. If this describes your experience with annuities, we want to help. Click here to discuss your options with an AnnuityAssist advisor.
2Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38, 56.