Posted by Don Martin on Fri, Nov 11, 2011 @ 02:39 PM
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Are annuities with a Guaranteed Income Benefit better than investing outside of an annuity?
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Recently a sales rep spoke to me about investing in annuities. He claimed his employer has an annuity that guarantees that the assets are protected in the event market goes down. However the Guaranteed Income Benefit (GIB) annuity only protects the amount of the annual withdrawal and not the entire balance. During the presentation I asked the rep “So it is like a Put option that protects the portfolio from a decline?” I thought he agreed with me when he implied that the entire account balance was covered from a decline. I expressed shock that this was available for 1.7% annual fee when Put options with a strike price at market are usually 10% to 20% of the value per year. He claimed it was due to wholesale purchase and having a huge diversified pool of annuitants. But he was wrong. I researched it and found that a GIB only insures the annual withdrawal (what they call an “income benefit” which is not really income but is a mixture of return of your original principal plus a modest profit plus mortality credit from participating in an annuity). I feel it was a willful misrepresentation by the rep to fail to say to me “Don, you misunderstood, the insurance company only insures the annual withdrawal and not the entire balance.” His failure to answer my questions in a clear way was part of a plan to obfuscate. I said to him that because the benefit of a Put option was 10 to 20% of the value of the portfolio and he was charging only 1.7% that his proposition did not make sense. A sales rep, when confronted with my accusation has two choices: either come clean and admit the benefits are not so great and thus he gains credibility by explaining that the product can work in a modest way in a credible manner, or he can play manipulative games and hope the prospect is dumb. The rep chose to hope I was dumb. So now I don’t trust the rep or his company or the GIB industry. As a fee-only financial planner I am not allowed to sell annuities because the huge commission they pay would create a conflict of interest. This encounter with the commissioned sales rep demonstrated to me why fee-only is the best way to practice financial services.
The annual withdrawal might be 5%, so the annuity company is only protecting 5% each year, not the entire balance. If you want to withdraw the entire balance then the guarantee does not apply. So assuming that a stock market depression lasts 10 years then the annuity company is on the hook for ten times 5% which is 50%, but using present value that would be reduced by 39% assuming a 5% discount rate. However the portfolio might yield 2% a year in dividends so the insurance company, to meet its guarantee, would lose 3% a year times ten years. So 3% times ten years times (1-.39) = 18.3% of a portfolio is insured. Then the insurance company might buy Put options that are “out of the money” with a strike at 15% below value for a modest fee. That way the insurance company keeps its costs low and limits its risk to a modest amount.
My objection to annuities is that the fee is 1.7% on top of the money management fee, the capital gains are treated as ordinary income, and there is no step-up of basis of capital gains when someone dies. The purpose of a goal of somehow getting “Put” like guarantee from an annuity would be to take risks with equities but part of the benefit of equities is the long term gain tax treatment, which is lost in an annuity. The benefit of stocks over bonds is that over the long run stocks beat bonds by 2-4% a year depending on which 20 to 40 year era you are in. (Some eras bonds beat stocks for 30 years). So assuming that stocks begin to beat bonds in 2017 or 2020 then if you buy an annuity you will pay 1.7% of the 2 to 4% equity risk premium plus another 1.4% of return will be spent on higher ordinary income taxes instead of using the lower long term gain rates. (If stocks return 7% in price and the capital gains rate saves 20% in taxes, that is 20% times 7% = 1.4 percentage points of after-tax return. Even more tax is saved due to step-up of basis on death for capital gains). So most of the benefit of stocks over bonds is ruined by an annuity during a time when stocks beat bonds. Further, if we are in a multi-decade era when bonds beat stocks then you would have less of a need for a stock Put option that the GIB annuity allegedly gives you.
An annuity is best used only if it has very low costs and is invested in bonds. Further it should be only a small part of someone’s net worth because if it is time to trade it for stocks then one would suffer from the tax traps and high fees of annuities that invest in equities. If investing in an annuity that holds bonds it would be best to wait to buy such an annuity during a time when interest rates are high, instead of today when they are very, very low. But then the argument could be raised that if bond rates are high and you bought them in a taxable account instead of annuity then you could make a good long term capital gain when rates drop the bonds will go up in value.
Will you get enough money when you retire?
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Ways to get roughly similar benefits without an annuity
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To replicate the GIB feature on his own an investor would need to set aside a pool of money as a buffer against several years of stock market crashes. Assuming a depression lasts 10 years and with present value one might need to contribute 6 years of cash to self-insure. The cash would be invested in short and intermediate term bonds. The 5% annual withdrawal could be handled by a mixture of dividends, interest and spending down some principal. If the portfolio had a yield of 2% from dividends and 4% from bonds and was 50% in bonds then it would yield 3%, so that way the spend down of principal would be 2% a year. The stereotypical portfolio for a retired person might be at least 60% bonds in order to reduce the risk of being hurt by a crash, although that is a very rough stereotype and should not be used without personalized analysis.
The difference between trying to replicate this on your own versus paying the insurance company for an annuity is that they guarantee it, but an investor on his own could be tempted to get lazy or distracted and make a mistake and spend down too much principal.
I have written an article “Equity Risk premium’s role in stock selection”.
Investors should seek independent financial advice.
