Variable Annuities Caveat
In this discussion of variable annuities, I am mostly making an implicit assumption that the annuity is competitively priced. Fees reflect what is needed to support the guarantees provided by the insurance company and to keep the company profitable. But fees are not excessive such that the value to the consumer is eliminated.
It must be noted that not all variable annuities are created equal. As will be discussed, they are complex financial instruments, and that complexity can hide a lack of competitiveness in the pricing of individual products. A variable annuity that is pitched along with a free dinner presentation is possibly not the type of financial product I have in mind. One should tread carefully. Due diligence and a comparison with other annuity options is needed to make sure that the product is priced fairly and will behave in the way that the purchaser understands it to behave. I do not want the “bad” annuities out there to free-ride off of my explanations about the potential positives that can be created by “good” annuities.
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Generally, the most efficient means for balancing protected income and investment upside is to combine life-only income annuities with aggressive stock portfolios. However, this requires a degree of investor self-control and long-term focus that may be difficult to achieve in practice. It requires accepting both the loss of liquidity as annuity assets disappear from the portfolio balance, as well as accepting a very aggressive asset allocation for what remains on the portfolio statement.
As a means for accommodating the concerns of real-world retirees, deferred variable annuities and fixed index annuities with lifetime income protections have developed as a compromise between downside protection and upside potential. We will cover variable annuities in this chapter and fixed index annuities in the next chapter.
Owners continue to see the annuity assets remain on their financial statements as part of the overall portfolio balance. As well, those assets maintain exposure to market upside that is not provided within an income annuity. This provides a behavioral benefit that makes the retiree more comfortable in considering a safety-first strategy incorporating risk pooling. The appeal to retirees is based on the combination of downside protection with a protected income stream, upside growth potential through their underlying investments (or links to investment indices in the case of fixed index annuities), and maintaining liquidity for the underlying assets, while also offering the potential for tax-deferral when compared with taxable investments.
For variable annuities, retirees can see their account values, they can continue to invest in funds (technically called variable insurance trusts, but similar to mutual funds) within the annuity subaccounts, and any funds remaining at death are generally available to beneficiaries as a death benefit, all while ensuring protected income for life.
Lifetime income provides insurance against outliving assets in retirement, resulting from a combination of either living too long and/or experiencing poor investment returns. As well, there are situations when variable and index annuities might help to achieve more efficient outcomes in retirement in terms of providing a better combination of spending and legacy. These relate to asset allocation and whether it may change when an income guarantee is in place. Income guarantees provide greater relative benefit to retirees who are either willing to invest more aggressively because of the guarantee, or who would otherwise be uncomfortable using stocks in retirement.
Those who accept the notion that the income guarantee increases risk capacity, and are willing to use a more aggressive asset allocation than otherwise both inside and outside of the annuity, could find that the additional exposure to the stock market equity premium more than offsets the annuity fees when markets perform well in retirement. The guarantee would also prove valuable if it otherwise stops retirees from panicking and selling stocks after a market drop. And when markets perform poorly, by paying an insurance premium for the income protection, one should anticipate depleting the underlying asset base sooner than with a lower-cost, investments-only strategy. But the annuity still includes a lifetime guarantee to support retirement spending after assets deplete, which is not the case with an investments-only approach. Investments-only strategies might last a bit longer, but spending stops completely once those assets are gone.
Second, variable and index annuities could create better outcomes for those who would simply use a lower stock allocation no matter the chosen retirement strategy, but who are unwilling to sacrifice the liquidity foregone with an income annuity. With a low stock allocation, investment assets are more likely to deplete, and again, the annuity provides the opportunity to continue with income for life even after the contract value of assets is gone. Without exposure to the risk premium, the contract value of underlying assets is more assured to deplete in the event of a long retirement. With investments-only, asset depletion ends the ability to spend, but an income guarantee assures this continued spending ability for life.
It is not possible to make any overall conclusions for or against variable annuities and fixed index annuities with income riders, as this depends on the personal preferences of individuals about the issues of upside and downside, the desire for liquidity, and the types of asset allocations which would be used both with and without the income guarantee in place. But there will certainly be cases when retirees can derive value from these types of annuities. After providing a quick summary of various annuity types, we explore this story first for a deferred variable annuity.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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