Apples and oranges – what do they have in common? Both are fruits!
Why would we start a discussion about annuity earnings with apples and oranges? When people start looking at annuities, they invariably want to compare them to mutual fund^s or other securities. Commonly, they will start the discussion about the merits of a particular annuity by asking about the “upside” or growth potential. Let us state this clearly – thinking of annuities as accumulation products by comparing them to securities is just plain wrong in the vast majority of scenarios. So let’s not mix apples and oranges.
Do annuities have growth potential? Sure, but do not decide to purchase an annuity expecting high single digit or double-digit gains, especially with today’s economic conditions.
Annuities are safety and security products that should be viewed in the light of their **guarantees. Dick and Eric examine what annuities really earn in this weeks video.
**Guarantees, including optional benefits, are backed by the claims-paying ability of the issuer, and may contain limitations, including surrender charges, which may affect policy values. During this segment, Dick and Eric are referring to Fixed Annuities unless otherwise specified.
In addition to your questions, this weeks inspiration came from…
Behind the indexed annuity curtain
We all saw the original Wizard of Oz movie when they went to see the powerful Oz and were totally in awe until the dog, Toto, pulled the curtain back to show that it was just some goober running a sound board.
That curtain needs to be pulled back on indexed annuities as well because “the show” is getting to be a little overwhelming on the lunch seminar circuit and with the increasingly aggressive online annuity promoters.
First of all, let me explain the details of an indexed annuity (also called an equity-indexed annuity, fixed-index annuity, hybrid annuity). An indexed annuity is a fixed annuity with a call option on an index, usually the Standard & Poor’s 500 Index. The vast majority of the call options are one year in length, but can be as long as five years. The S&P 500 index represents over 90% of the index option choices even though other index selections (Dow, Nasdaq, etc.) can be found in some product offerings. These call options allow you limited participation in the upside of the index (not including dividends).
When indexed annuities were developed a couple of decades ago, they were designed to compete with CD returns, not market returns. They were never put on the planet to be a pure growth product, even though they are sold that way by agents and the online annuity spammers. Realistic and historical (yes agents, these are also called facts) return expectations for indexed annuities should be around 3% to 5% annually. Those annual gains, if any, are locked in at the contract anniversary date, and then a new index option starts.
Please understand that indexed annuities are complex products, and the majority of agents are unable (or unwilling) to properly explain them and usually just focus on a few sizzle points. Below I have listed some of the positive and negatives of indexed annuities and where they might work within your portfolio.
- Used with Income Riders for target date income planning
This is how I use indexed annuities for my clients. I also attach contractual death benefits or confinement care benefits when that is the ultimate goal.
- Downside protection
Because your potential gains are attached to a call option, if the markets go down and the call option expires worthless at your contract anniversary date, then you will not lose any money. Agents use the phrase “Zero is your hero.” That’s a pretty goofy way to put it.
- Gains locked in
This is a very good feature of indexed annuities. If you have gains from your index option, that gain is locked in permanently, never to go below that amount. Just remember that your upside potential is very limited, regardless of what your agent tells you.
- Possibility to capture market dips
As an example, if the S&P 500 index goes from 1,300 to 900 in one year, your index option for that year would not credit any gains, but you would start the next index option year at 900 on the S&P 500.
- Higher actuarial payout for income
Most indexed annuities, when used for lifetime income purposes with attached income riders, have a higher actuarial percentage payout than similarly structured variable annuities#. [Read More…]
Annuity Guys® Video Transcript:
Dick: Today we want to talk about annuities, and we want to get all the hype out of the way, Eric.
Eric: The hype? There’s hype in annuities? Oh my gosh.
Dick: Well, this was inspired by Richard out in Massachusetts, one of our folks that had used the website and we had given him a referral. He sent in a question that basically said, “You know, I’ve been looking at different blogs on the Internet, and they’ve talked about the return, and the annualized return doesn’t seem to be that high.” And that’s true, isn’t it?
Eric: This is where people have the challenge. When they first start looking at annuities, they’re coming from a world where they’ve been focused on accumulation.
Eric: When we look at the mutual fund^ industry, everybody talks about, “I did this return, 20%, 30%.” “Oh, I beat the S&P.” That’s the accumulation world. The focus there is on numbers, the return I’m getting.
Dick: Exactly. Right. Is there a little hype in that world?
Eric: Oh there’s a lot of hype. You know, glossy pages with the charts that go like this. Oh my gosh.
Dick: Well, and we can look at DALBAR studies that talk about the individual investor and what they actually do earn, and it’s down below 5%, considerably below 5%. So it’s all over the board.
Eric: But must people have been conditioned to focus on the return.
Dick: Of accumulated money. Right.
Eric: Yes. I’m making this much. I’m making this much. I’m getting this much. That’s not what an annuity is about. It’s not about taking and trying to grow the asset so much as preserve it, because you’ve already done the saving part.
Dick: You’ve already done the work. You’ve built the nest egg.
Eric: What’s the goal of saving? It’s future spending. Saving is really, in this case, future spending.
Dick: Right. So would it be fair, Eric, to say that an annuity is more about security and cash flow?
Eric: Yes. Yes, it would. I would say that would be fair.
Dick: So if we were to boil it down and just get rid of all the hype, and when I say “hype,” I mean the way its presented, it may not really be hype, but it does sound good. We talk about 7% rollups on the income account and 8%. W talk about 5% payouts and 6% payouts. But if we really got down to the life expectancy and drawing the income off an annuity . . . well, first of all, let’s just talk about an immediate annuity. What would the real internal rate of return be on an immediate annuity overall?
Eric: One, two percent.
Dick: Max. One to two percent.
Eric: My thing, when we start talking about annuities, and we’re doing it now, talking about rate of return, first question I have to ask you is: When are you going to die? Then I’ll tell you what your return is going to be.
Dick: Exactly. The insurance company has this figured out statistically, and they know that, overall, your rate of return on this annuity in a statistically generalized averaged sense is going to be in the neighborhood of a couple of percent on an immediate annuity. Right now, with today’s rate, even a little less than that. Yet billions and billions of dollars of immediate annuities are sold. Why do people do that?
Eric: Safety, security, cash flow. We’re going to repeat ourselves a lot here. If you’re going to be focused on return, don’t go here.
Dick: Exactly. I know we both have got a lot to say here. But one thing that comes to my mind is all of the sure bet things that are out there in the investment world, the things that you are told you cannot lose, such as Enron, Lehman Brothers. What are some others?
Eric: Well, GM was always the . . . I grew up in a world where they always said buy GM stock, and you never have to worry.
Dick: Right. Enron? Madoff? So these are things that all look good, but those are all followed by this caveat of past performance is no indicator of future results. We tend to gloss over that and say, “Oh, they just say that.” But that’s there for a reason.
Eric: Right. But it’s a risk-reward aspect. You’re chasing the reward there and are willing to take some of that risk. What we talk about when we look at annuities, we want to take that risk and diminish it significantly so that you have that safety, you have that **guarantee.
Eric: And that’s what we’re focused on with annuities.
Dick: And that’s not for all of a client’s money.
Eric: Not all of your money. That’s right. Asset allocation, spreading the baskets out.
Dick: It’s a further diversification, another layer of protection and safety completely. And now if we get into the very popular indexed or hybrid annuity, there are a lot of things to talk about in terms of that income rollup and how it gets your income up to a certain level by a certain age, which would not be **guaranteed if you were in the market. You maybe couldn’t take that big of an income without depleting your principal much faster. So there is that aspect. But if we just talked about the overall rate of return of that hybrid annuity, we took it like some of these guys do, and they’re very good at their math and their spreadsheets. They spread it out and they show if you start a guy out at 60 years old and you defer him for 5 years or 10 years, with this 7% rollup, you turn it on, and he lives to age 90. What’s his return going to be?
Eric: Like two, three, four, five percent, perhaps. That would be on the high end.
Dick: On the real high client.
Eric: It depends on when you start.
Dick: Two percent on the low and maybe, like you say, four to five on the extreme high, but more like two to there percent would be like the max. They’re are part of the rule.
Eric: Part of what we’re looking at is we’re looking at pieces in today’s environment. Caps right now are structured around what today’s caps are.
Eric: So when we’re looking at things, we like to today’s numbers. Now, we expect caps will increase in the future. Can we **guarantee it? No.
Eric: And that’s what, when we work with annuities, we really like to talk about **guarantees. Because if you’re satisfied with the **guarantee, then anything above and beyond is good.
Dick: That’s right.
Eric: And the same thing is true on the indexing side of these components. Look at what the **guarantee is. That indexing component offers a little bit of a bump. But, focus on the **guarantee.
Dick: Right. Well, folks, I think for today’s topic we want to thank Richard. Thank you Richard for that good question. Eric and I added something at the first of the year that you may not have seen on the blog site. So when you’re through with this, if you’d like, you can actually ask us a question.
Eric: That’s right. We’ve put it out there in a couple different spots. We encourage you . . . as we come up with topics, sometimes it’s nice to know what you want to actually hear about.
Dick: Right. We tried to dispel the hype here and get down to the real rate of return is and then talk about the real reason that you do an annuity and choose an annuity.
Eric: No hype, just answers.
Dick: Thank you.