Annuity Guarantees: Finding the Devil in the Details
What Is An Annuity Guarantee?
Many guarantees are designed to give the annuity holder protection, often on their income, from negative market environments. However, many of these guarantees work best under less probable circumstances the insurance company is betting against—like when the annuitant lives longer than the insurance company's life-expectancy tables—and some require annuitization of the contract—typically irrevocable once annuitized.
Annuitization (the original method for guaranteeing income) trades the contract value of the annuity for a steady stream of income with a predetermined end date (number of payments, death, etc.). However, after annuitization, and without an additional rider, the residual value of many annuities belongs to the insurance company once the annuitant passes away. Additionally, without an applicable rider in place, the predetermined payments are usually not inflation adjusted—which could leave the annuitant with less purchasing power in the later years of the contract. In our view, the only situation where annuitization aides an investor without an additional rider, is when the annuitant lives longer than the insurance company's actuarial tables suggest they will.
More: Download Annuity Insights: Nine Questions Every Annuity Investor Should Ask
Annuity guarantees come with varying terms by the type of contract purchased. And some, like variable and indexed annuities, have a lot of rider options. Many of these riders come with conditions and requirements affected by the purchaser's actions early in the contract's life. And those actions could prove costly, since they come with higher fees or performance caps (often used in indexed annuities). So let's shine some light on the dark side of some common annuity guarantees.
With fixed annuities, the guarantee is typically on an annuity's market value and the interest rate over a given period. Essentially, it's a safety of principal and a fixed interest rate. No real devil here, simple fixed annuities have always been fairly straight forward. However, their current low interest rates, and contracts with high introductory interest rates are something many investors may not be able to afford if they need growth in their portfolio.
Fixed Indexed Guarantees
Indexed annuities also guarantee the contract's market value—creating no downside volatility (no negative returns). However, despite the seemingly remarkable sounding guarantee of no downside, these devious contracts make use of complicated formulas to calculate the performance and ultimately, the value of the contract. Keep in mind, indexed annuities were designed to compete with CDs, and often use performance caps, participation rates, margins, changing contract terms and indices that exclude dividends to limit returns. We believe the cost of the guarantee for these contracts may make them an unaffordable option for investors seeking growth.
Variable annuities have a lot of rider options to choose from. However, typically once a rider is attached to the contract, the insurer can limit exposure to equities or require a minimum exposure to fixed income securities—reducing the insurer's liability. Unfortunately, it also means many investors may receive a reduced benefit from the guarantee they paid for. And even with the guaranteed income payment, the contract's purchasing power may be reduced if there is no inflation adjustment rider. Lastly, variable annuity contracts often come with waiting periods on their riders (this is separate from a surrender penalty period), and can be as long as 10 years! While variable annuities typically have the most potential for asset growth amongst annuity investments, the limitations and high fees associated with these contracts again raises the question of affordability for investors.
In fact, expenses associated with guarantees and riders can be a large portion of annuity contracts sold today[i], and may have hidden side-effects for investors and financial markets alike. In a recent report from the Financial Stability Oversight Council (FSOC), annuities with guaranteed living benefits (GLBs) can have "meaningful financial risks" with regard to the U.S. financial system. How so? In simple terms, the more annuity contracts with GLBs get issued, the more derivative contracts the insurer buys to offset their liabilities—leaving insurance companies exposed to derivative investments as a way to back their guarantees. This begs the question, who's guaranteeing the guaranteed income? And more importantly, can annuity buyers afford the contract's guarantees?
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[i] Source IRI Factbook, 2015, page 19. "In 2014, 72% of variable annuity sales were in products offering living benefits, making this product the clear market leader."