The Truth About Annuity Income Strategies
Michael Tove Ph.D, CEP, RFC
January 2015
WHAT IS AN ANNUITY?
The term “Annuity” means “annual income” and applies to not just products from insurance companies but to corporate pensions, Social Security Income, even lottery and sweepstakes winnings. Common to every form of annuity payment is that the income recipient, called the “Annuitant” receives a series of payments – income – for a specified period of time, commonly for life.
Half a century ago, few people needed worry about outliving their retirement income. In 1950, 86.9% of men worked for a corporate employer (Kutscher 1993). Most, especially the larger corporations offered benefits which included a retirement plan for life. These Defined Benefit plans (commonly called “pensions”) guaranteed a specified living income; one that employees knew about and could rely on for their retirement years.
In large part, Defined Benefit Plans of the mid-twentieth Century worked because long-term markets were a lot more predictable than today and because the life expectancies of retirees was a lot shorter. For example, according to the U.S. Department of Health and Human Services National Center for Health Statistics, the average life expectancy of a male employee in 1950, retiring at age 65, was 12.9 years and 15.2 years for women. By 2011, those life expectancies jumped to 17.9 years for men and 20.5 years for women. Since the start of the 21st Century, the average life expectancies for a 65 year-old have increased at a rate of about 1.5 months per year. That may not seem like a lot in a year or two, but over long time, it is quite significant.
Following the “Dot-Com” market crash of 2000, employers began feeling pressure from two conflicting sources. First, their ability to rely on rising markets to sustain the financial basis of their pension guarantees was shaken up and increasing life expectancies meant that not only was there less money available to cover their pension guarantees, those promises had to last a lot longer. As a result, employers began a wholesale back-pedal on the type of retirement plans they offered, switching from Defined Benefit (pension) plans wherein they had the risk of satisfying an uncertain future promise of income to Defined Contribution Plans (most commonly called 401(k) Plans) that passed the risk of future income onto the backs of the employees.
However, the shift away from Defined Benefit (Income) Plans toward Defined Contribution (Accumulation) Plans began much earlier. The 401(k) Plan was created by passage of the Revenue Act of 1978, and named 401(k) after its corresponding section in the tax code. Initially, they defined only the rules of contribution by employees but by 1981 were expanded to include automatic salary reduction and corporate matching allowances.
The biggest difference between traditional Defined Benefit Plans and new Defined Contribution Plans is that in the former, the employee receives a lifelong promise of income, often including the employee’s spouse. Conversely, with Defined Contribution Plans (401(k) Plans), no such promise exists. In effect, the promise of lifetime income from these Defined Benefit Plans made them an annuity and Defined Contribution Plans are not.
Because Defined Contribution (Accumulation) Plans have no built-in provision for income, investment advisors began devising strategies to convert accumulated sums of money into income. Annuities certainly existed but the traditional annuity schedules were, on the surface, unattractive because an entire retirement account would necessarily be converted to a fixed income with no access to money and no residual death benefit. Many retirees, with NO accumulated assets other than their 401(k), felt that exchanging their entire life savings for a modest lifetime income that never increased for inflation, was unattractive. An alternative was needed; one that offered permanent income with continued growth and future death benefit. In other words, they wanted to “have their cake and eat it too.”
Perhaps the most popular solution to emerge was the “4% Rule” (Bengen 1994, Scott et al., 2008). This strategy suggested that permanent, reliable income could be generated by withdrawing 4% of any investment portfolio and relying on growth to replenish the balance. Prior to the Dot-Com Bubble crash of 2000, it seemed to work. In no small part, the early years of success for this strategy were buoyed by the largest Bull Market in United States history to date.
Unfortunately, with the Dot-Com Crash – and beyond into the 21st Century, the 4% Rule has been shown to be flawed. For example, research by Nobel Laureate William F. Sharpe, and colleagues (Scott et al. 2008; see also Greene 2013, Voegtlin & Pfau 2014) reported a 57% change of failure using this strategy. To date, no retirement plan strategy other than an annuity can guarantee a permanent source of income.
NOT ALL ANNUITIES ARE ALIKE.
There are as many different kinds of annuities as there are different kinds of cars and like automobiles, some are better “higher performance models” than others. Annuity pundits, especially the nay-sayers love to decry that “annuities are terribly complex” (and thus should be avoided at all costs). But, annuities are only complicated when trying to understand ALL of them at once; as if all annuities were rolled into one. It’s no more fair or accurate than assuming every feature of every make and model of every motor vehicle in existence was to be found in a single car – and that to drive the car, you had to be a master mechanic, able to disassemble and reassemble the engine, transmission and computer of that non-existent vehicle.
To understand what annuities are, one must first understand the different kinds of annuities; different makes and models as it were. The following is a simple overview.
Immediate Annuity – This is an account designed to create income starting immediately; essentially a “Personal Pension.” You have accumulated a sum of money through any imaginable resource. Now it’s time to live off it. The Immediate Annuity (also called “SPIA” for Single Premium Immediate Annuity) will convert that sum into an income (monthly payments of a precise amount) for a stated period of time. The term of annuity payments (called “Annuitization Schedule”) may be for a specified number of years (e.g., 10, 20 or 30 – called “period certain”) or for life (called “life certain”), or for two lives (“joint and survivor”) or a combination of life with a minimum number of years guaranteed. In other words, they offer many different possible annuitization schedules.
In all cases, the terms of payments are precise and guaranteed, but the amounts of annuity income will vary based on the schedule elected. For example, an annuity value of $100,000 will pay $10,000 per year if annuitized for 10 years certain but $5000 if for 20 years certain. If the annuity is funded with after-tax (non-IRA type) dollars, each monthly payment includes a portion of principal (non-taxable) and interest (taxable). However, this “exclusion ratio” (amount of the income that is NOT reported as taxable) can produce a significant, tax-advantaged income which, for retirees living (in part or in whole) in Social Security payments, can reduce or even eliminate income tax on the Social Security income received. (See articles on how Social Security Income is taxed).
Deferred Annuity – Any annuity which grows money before converting it to income is “deferred.” ALL annuities other than Immediate are Deferred. Within the Deferred Annuity category, there are two groups:
Variable Annuities and Fixed Annuities.
Variable Annuity – This is an investment portfolio (typically mutual funds) nested within an insurance wrapper. The annuity owner assumes all the liability of market performance including the possibility that a negative market could invade principal. The advantage to the owner is that because annuities offer tax-deferred growth, an investor may buy and sell mutual funds (inside the annuity) and avoid capital gains taxes. They also may buy and sell across different fund companies and not incur sales charges or worry about meeting break point thresholds within a single fund family. However, Variable Annuity companies must hold deposits in a separate account (the money is invested in the mutual funds). Because they do not have access to the money, they cannot earn money on the money except by charging annual fees to own the annuity. Many Variable Annuities also offer secondary minimum guarantees (called GMWBs or Guaranteed Minimum Withdrawal Benefits). These GMWBs are often promoted as annuity safety nets (like Fixed Annuities) but more accurately, they’re secondary insurance policies that for a premium, promises to repay to the owner a stated amount IF there is a loss below a defined threshold.
Fixed Annuity – This is a type of annuity where the issuing company, not the owner is exposed to risk of loss to negative market returns. Technically, a Fixed Annuity is one where the issuing company has direct access to the annuity funds, may combine those funds with all other premiums and funds in the company’s general funds account and can make money directly from those moneys. There are regulatory restrictions on HOW the company may invest the money but because the company can make money directly off the owner’s deposit, there is no need for a fee structure.
Fixed Annuities can be further categorized in two ways: MYGAs (Multi-year Guaranteed Annuities) and FIAs (Fixed Index Annuities).
MYGAs, sometimes called “CD Annuities” resemble CDs in that they promise to pay a stated amount of interest for a specified period of time. However, unlike CDs, MYGAs usually permit penalty-free access to some of the money each year and at the end of the deferral term, may not require renewal.
FIAs are Fixed Annuities that credit growth by indirect measurement of one or more stock market indexes. The basic premise in a FIA is that owners can enjoy upside potential proportional to gains in rising markets but remain protected from loss in falling markets.
GENERATING INCOME.
Harvard and MIT economist and Nobel Laureate Robert Merton (2014) warned that the majority of employer-based Defined Benefit retirement plans (e.g., 401(k)’s) are committing a fundamental error by emphasizing accumulation rather than future income. Specifically, he recommends that better than a portfolio of mutual funds for which there is no guarantee of future value much less income, retirement plans would be well-served if built upon “deferred inflation-indexed annuities.” However, while all annuities share the ability to generate income, there are different strategies by which different annuity products do this.
Traditional Annuitization. All annuities include the ability to annuitize the same contract, duplicating the strategies offered by immediate annuities. The good news is that these income promises are guaranteed and can, by their “exclusion ratios,” offer tax-advantaged income. The bad news is, especially during times of low interest rates, the amount of credited interest (“IRR” or “Internal Rate of Return”) is minimal at best and in some cases, actually negative meaning if a person lives his/her average life expectancy, the income paid is less than the annuity is worth!
Penalty-free Withdrawals. With few exceptions, all annuities offer penalty-free access to the deferred account value. Often, annuity owners elect to generate income by simply withdrawing some of their contract each year. This is a very effective, and relatively safe strategy with fixed annuities because policy owners have no direct exposure to investment markets. However, when income is withdrawn from variable accounts (equity investment portfolios, Variable Annuities), there is significant risk in that withdrawals against a falling market tremendously accelerate the account’s depletion and incur the very real risk you’ll outlive your money (see Greene 2013; Voegtlin & Pfau 2014).
Income Rider. The latest approach to income generation is through the use of an income rider. Many fixed annuities and all variable annuities charge an added fee for these features but as a general rule, the amount of income that can be generated is better than through traditional annuitization and unlike that strategy, can include a death benefit in addition to the lifetime income guarantee. But between fixed and variable annuities, the similarities end there.
Variable Annuity GMWB Riders. Critical to understanding of how GMWB (“Guaranteed Minimum Withdrawal Benefit”) riders work is recognition that invariable Annuities, the insurance company does not have direct access to the funds in the account and therefore cannot use those funds to earn money for their own account. They make their money from fees charged.
And because the underlying account is invested in the stock market (mutual funds), the issuing company assumes enormous risk in promising a Variable Annuity owner some pre-determined amount of future account value and/or return because in the event of a market plunge, the company may be promising money which they don’t have and essentially does not exist. Simple logic alone tells us no company can or would do that.
So how can they offer these GMWB riders? The answer is traditional annuitization based on minimal payout schedules. Let’s back up. Assume Company X offers 5% minimum return per year with a minimum guarantee to return premium. It’s called a “Roll-up” value. There are several fees associated with such a Variable Annuity. First is the basic cost of insurance known as the “M&E” (“Mortality and Expense”) charge. Typically that runs between 1.0 and 1.5% per year. Plus there is a GMWB rider charge, also typically between 1.0 and 1.5% per year. Plus there are mutual fund charges that typically average 0.5 to 1.0% per year. Add it all up and the total charges on a Variable Annuity are 2.5% to 4% per year. Let’s assume 2.5%. That means the Variable Annuity will not generate a return greater than the GMWB value unless the underlying investments nets more than 7.5% per year (which as a ten-year running average, has not happened in the 21st Century).