It is becoming more and more common that I will talk with an individual and they ask me to take a look at an annuity that they either own, or have been considering for purchase. And more often than not, the annuity they are referring to is a variable annuity.
One of the primary attractions to variable annuities is the idea that one can capture market returns and have a guaranteed income for life, no matter what the happens in the market. Now, as most investors know, the idea of capturing market gains while having little or no risk of losses is not feasible. Somehow, however, the insurance companies have managed to persuade intelligent people into believing that not only is it feasible, but that they can also have the benefit of a guaranteed income for life and, in some cases, even a death benefit. This idea reminds me of the time a friend of mine said to me, "Did you know that 2 = 1?" Now, there is no question that 2 is not equal to 1, but he was anxious to prove it and I was curious to see how he could make it happen, so with his sheet of paper he proceeded to step through it like this.
The marketing behind many variable annuities is really not much different. With so many moving pieces, formulas, and "IF" scenarios, it is not hard to imagine why so many people purchase a variable annuity hoping that it is as good as it appears, even though they are not real certain how it works. To better illustrate this, I have posted a page from the marketing brochure of a popular annuity provider.
** Click the image to enlarge.
Here we have a $500,000 investment going in at the end of the year when the annuitant is 65 years of age. This particular product also features an optional Guaranteed Minimum Income Benefit rider (called the GMIB Plus) that is marketed as protection of your future income if your account value declines. And that is exactly what happens to the account value over 20 years for the example couple. It goes from a $500,000 initial investment to only $356,094 after 20 years. A loss of $143,906! Now at age 85, this couple is happy because they purchased the GMIB Plus rider. Even though the account has lost 28.78% of its initial value, they have that huge $1,382,291 Income Base where they can still begin taking an $81,383 annual payout under the joint life payout option in the GMIB Plus. Wouldn't you be happy with that? Should you consider protecting your future income benefit by purchasing this variable annuity? Maybe…but, before you do that, let's make sure that we understand what this page is really showing us.
Gross vs Net return
In the left column they have displayed the Gross Annual Return of the investment. The gross return is the return before fees and expenses. What the insurance company is not showing is the net return our example couple achieved. Instead, they show the account value. In the first year, their account grew 6.15% to $530,749 from the initial $500,000. The gross return that year was 9.64%. Had they achieved a 9.64% return on their $500,000 investment that year, they would have $548,200 in their account. Therefore, they had a lost opportunity of $17,451 due to fees and expenses of this annuity. If you review the disclosure statement at the bottom of the page you see that the gross average annual rate of return in the example, for the entire period, is 2.32%. That means that without the fees and expenses from the annuity, Lisa and Carl would have had $791,007 at the end of year 20, when they were 85 years old. Instead, their account value is $356,094. A $434,913 difference!
The Income Base
In the far right column the insurance company displays the growth of the 5% compounding income base. In my experience, this is where most of the misunderstanding occurs. Many people purchase an annuity with the perception that this income base is actually the value of their annuity. And understandably so, since most of the marketing information draws your eye to this column and the whole idea of this annuity is to capture market gains and continue to grow future income when the market declines. The reality that many people learn later on is that the income base is just a number used to calculate future lifetime income payments under the optional GMIB Plus rider. The income base is NOT an account value. Because it is not an account value and is just a number used for calculation purposes, it will not fluctuate with market conditions, nor can it be taken as a lump sum distribution.
Other Thoughts
As I mentioned above, the gross average annual return for the 20 year period in the illustration was 2.32%. It is worth noting that the worst 20 year period for the S&P500 occurred from 1929 - 1948. During this period, the total average annual return was 3.11%. So, while the average annual return in the example is certainly possible, it would be a first. Using the actual 3.11% worst 20 year period of the S&P 500, Lisa and Carl's initial investment of $500,000 at age 65 could have grown to $922,122 when they were 85. If they continued to earn only 3.11% annually, they could still receive an annual income of $81,383 until they are 99 years old.
Adding insult to injury, the death benefit for Lisa and Carl's annuity will likely be exhausted in a few short years. Once they begin taking the $81,383 the insurance company will pay this income to them in the form of a distribution from their account value, and continue to charge the annual fees and expenses, until the account value is zero. At that point, there will no longer be a death benefit for their children. And since their annual fees & expenses have eclipsed $22,000 by the time they are 85, it's safe to say that Lisa and Carl probably won't have any account value in four years.
Summary
Without knowing it, Lisa and Carl have just executed a substantial transfer of wealth away from their family to this insurance company. Over the 20 year period in this example they have already paid hundreds of thousands of dollars in fees and expenses. They invested $500,000 in a variable annuity with this insurance company for 20 years, and after four short years of receiving only $81,383 per year they will likely have a zero account balance and no death benefit to pass on to their loved ones.
In the end, the question is, how much is that guarantee really worth? Are you paying too much for nothing?
Kevin Warman
(last updated 12/28/2015)