Annuity dreams and contractual realities
Too many annuity purchases are made with the hope that the product really is too good to be true. It’s always best to base your decisions and your expectations only on the guarantees within the annuity policy.
An annuity in its basic form is a contract between you and the issuing carrier. Spelled out in the policy verbiage is exactly what the annuity will do. Annuity company lawyers and actuaries make sure that you know in writing what you are going to get in a worst-case scenario, which is all you should care about. It’s important to understand the good, the bad, and the limitations of the most popular annuities before buying, so let’s take a look at some of the need to know realities of these often misunderstood strategies.
Separate calculation realities
If you draw a line down the middle of a blank sheet of paper, the left hand side of the ledger for a deferred annuity is what’s called the accumulation value, and the right hand side is the separate benefits (aka: riders) valuation. It’s very important to understand how you can access and use all of these separate calculations, and to be aware of the policy rules that are in place. Unfortunately, I find that this separate calculation confusion is where a lot of the annuity misinformation lies and where the annuity dream most often dies. I have come to the conclusion that the majority of the time, the contractual realities of the annuity always win in the end.
Accumulation value dreams
The accumulation value is what the annuity industry calls the amount within your annuity that you can access lump sum. This is the value that surrender charges would be applied to within a deferred annuity, and the amount you can transfer to another annuity or cash out in full. This is the investment side of the annuity, and the vast majority of annuities sold today are variable and indexed annuities. This is where the annuity dream lives, and definitely where the annuity dream is sold.
The accumulation value of a variable annuity is based on the performance of the separate accounts (aka: mutual funds) offered by the specific product. Each carrier and each variable annuity have different mutual fund choices, and usually have restrictions on how much you can switch between funds. Valuations can go up and down, and your accumulation value is only as good as the management of the separate accounts. The dream of growth can also be affected by high annual fees and limited fund choices. Many carriers also limit these investment choices if additional benefits or riders are added to the policy.
Because of the dream of market returns, most variable annuities have lower contractual benefits and guarantees than their fixed annuity cousins. Regardless of this fact, the vast majority of annuities sold today are variable because people want to have their cake (supposed unlimited upside) and eat it too (some contractual guarantees). It will be interesting to see how the next market downturn realities affect the dreams that were purchased.
Fixed-index annuities (aka: equity-indexed annuities) base their return on a call option on an index, usually the Standard & Poor’s 500 Index. Indexed annuities were actually designed to compete with CD returns, so it really can’t be included or rationally considered from a market return standpoint. The good news about an indexed annuity is that it is a fixed annuity, which means that your principal is protected. In addition, gains (if any) are locked in on an annual basis and typically on the contract anniversary date. This one day per year return dart throw, in addition to limits (aka: caps) on the upside keep the contractual realities of indexed annuities in the CD return category.
I always tell people that the upside to an indexed annuity is that there is no downside (which is a good thing), and the downside is that there is typically very limited upside (i.e. CD type returns). You can’t have it all, which is OK when you align your return expectations with the realities of the policy. Remember, there is no too good to be true product out there, and especially with annuities.
Annuity Monopoly money
In my draw the line down the middle of a page scenario, the right hand side of the ledger is the benefit side. That could be an income rider that guarantees an annual percentage growth for future income, or a death benefit rider that guarantees an annual percentage growth for legacy. There are also attached benefits (aka: riders) that can transfer the risk for long term care or confinement care.
The catch to these attached riders is that you can only use that calculation for the specific benefit it solves for. For example, income riders can only be used for income. You can’t access that calculation in a lump sum, or peel off the interest. It is a separate valuation from the accumulation value, and should not be confused with that walk away amount.
I was recently asked a very good question by a very smart Wall Street “name.” He wanted to know what percentage or amount of the $200 billion sold annually in annuities would be sold if people made their decision on the contractual guarantees only, and not the dream of the over-hyped potential returns. There is no way to know that answer, buy I told him that my personal guess would be 50% to 60%.
He was a little shocked that I came in that high, but as I reminded him, a lot of people are looking for annuity type guarantees and transfer of risk benefits. That’s what they want, that’s what they will continue to buy, and that’s how all annuities should be sold. Annuity strategies do have their place in some but not all portfolios.
Always remember to own the annuity contractual reality, and not buy the dream.
Originally published 10.22.13 on MarketWatch.com – http://www.marketwatch.com/story/annuity-dreams-and-contractual-realities-2013-10-22