The past few years of roiling, tumbling markets have struck fear in the hearts of many investors and sent some searching for a port — gold, CDs, guaranteed investment contracts — in which to wait out the storm. Annuities, long derided as overpriced insurance-cum-savings accounts, even have enjoyed a new popularity. A bear market will do that.
Annuities cater to shell-shocked equity investors by offering a host of guarantees on returns. Actually, fixed annuities, which currently offer a guaranteed minimum return of about 3 percent and a steady interest payment, have enjoyed robust sales of late while variable annuities, which fluctuate with the stock market, have dropped in popularity. Add-on features to variable annuities, however, can offer a tempting combination of equity growth potential and protection against loss. “If there's one overriding trend in the variable annuity marketplace today, it's people trying to figure out how to offer guarantees,” says Lorry Stensrud, executive vice president at Lincoln National Life Insurance in Fort Wayne, Ind. “People want equities without the downside.”
The basic deferred annuity is a long-term savings vehicle in which funds grow tax-free during an accumulation phase of 10 to 30 years and are paid back during a future payout phase.
Insurers have created a number of riders that, for a fee, can be attached to the basic annuity contract to accomplish various goals. Most insurers now guarantee some kind of minimum return on your investment. It may be that any money paid into the annuity goes to heirs when you die, or an annuitant can guarantee a minimum income level during the payout phase, or lock in gains on principal after a waiting period. Other riders offer long-term health care benefits and sign-on bonuses. All these add-ons add to the cost of the annuity, of course, and they can be bewilderingly complicated to understand. Still, you can't appreciate variable annuities without some basic understanding of their “bells and whistles.”
The most long-standing option is the guaranteed minimum death benefit. This benefit ensures that if the purchaser dies before the annuity starts paying out, his beneficiary will receive either the current value of the annuity or the total premiums paid (minus any withdrawals), whichever is greater. The death benefit ends after the annuity starts paying out, but clients can purchase a “term-certain” option, which pays a death benefit for a set period, say 10 years, after the contract has been annuitized.
“The amount of money you invest in the contract will be payable to your beneficiary irrespective of market conditions. This is very important right now,” says Richard Austin, former president of Templeton Funds Annuity Co. “If you put all your money in a technology fund portfolio three years ago, it could be worth 10 to 30 cents on the dollar today. With the guaranteed death benefit, the beneficiary would receive 100 cents on the dollar.”
During the bull market, insurers enhanced the death benefit by adding the ability to lock in gains on the principal after seven years — even every year — so that clients now can choose the greater of the annuity's current value, the total premiums or the contract value on its anniversary date. Newer products create a second fund to help beneficiaries pay the taxes on annuity earnings. American Skandia's Plus40, for example, contains a traditional death benefit plus a tax-free life insurance fund that pays 40 percent of the annuity account value at death. “If the owner dies, 100 percent of the gain is taxed as ordinary income,” explains Patricia Abram, senior vice president and chief marketing officer at American Skandia in Shelton, Conn. However, “forty percent of the account value is in the form of a life insurance death benefit, and so it's taxfree.”
Of course, many clients are interested in securing enough money to live on rather than in leaving a hefty legacy. For these clients, there is the guaranteed minimum living income benefit. These benefits ensure some principal protection for the contract holder, guaranteeing that she will get back the amount she put in plus some small interest after a waiting period, typically seven to 10 years. Some insurers protect the principal by automatically channeling a certain amount of the investor's premiums to a fixed income subaccount when the markets head south and moving funds back to equity subaccounts when the market improves. After, say, seven years, an annuitant can be sure that she will receive either 100 percent of what she put in or the account value on any contract anniversary, if that's higher.
Another variable annuity option lets investors earn a guaranteed minimum instead of the actual returns if the investment does poorly, thereby offering the upside without the downside. The fixed annuity version of this option is called an index-linked annuity, which guarantees a minimum interest rate, often 3 percent, plus potential for higher returns through ties to a stock index, such as the S&P 500. However, the client only participates in a percentage (30 percent to 80 percent) of any market appreciation and receives no gain from dividends.
A third option for those looking to ensure income is a rider guaranteeing that once a variable annuity starts paying out, no payment can be less than some stated percentage of the initial payment. Nervous investors might also feel calmed in this case by built-in features that can dollar-cost-average funds from a fixed-income subaccount into equity subaccounts or automatically rebalance funds allocated to various subaccounts.
A more recent innovation allows clients greater access to the annuity funds. Usually, the payback phase of the annuity consists of one of three options: a lump-sum payment, systematic withdrawal (regular withdrawals until the money runs out) or annuitization, in which the insurer guarantees your income for life with payments based on projected earnings and actuarial tables.
Some riders, however, now give clients both systematic withdrawals and the lifetime annuity. Lincoln's Income4Life option lets annuitants make withdrawals during a special “access phase.” Of course, if they withdraw too much, the remaining annuity payment could be miniscule. The Hartford's Principal First guarantees the initial investment as long as clients don't withdraw more than 7 percent of the account value in any one year.
Companies like American Skandia and Pacific Life Insurance offer clients a sign-up bonus or a form of “matching” contribution of 1 to 6 percent when they first purchase the annuity, and sometimes every time they make a premium payment. An enticement is an offer made by companies such as Nationwide Financial to cover a home health aide or nursing home care without diminishing the annuity income payment, but these may cost up to $20,000 more in initial investments. They also may require a serious diagnosis or a seven-year waiting period to kick in.
Each rider, starting with the guaranteed minimum death benefit, adds to the annual cost of the annuity. It may be only, say, 20 basis points, but that eats into returns, and multiple riders can wind up taking a large bite. “First, the death benefit was the return of your initial investment, then someone adjusted the death benefit every five years, and then every year, and then every two weeks,” says Stensrud. “So all of those things added fees.”
Each rider carries its own restrictions, too. The principal may be guaranteed after seven years, but you may have to reelect that rider and wait another seven years to extend that protection.
The fact that stocks historically over time come out ahead during rolling 10- to 20-year time periods argues that the investor doesn't need to pay extra to get guarantees for funds that are usually invested for that long anyway. “If you're a long-term investor, the death benefit is not very meaningful,” says Peter Di Teresa, a senior analyst at Morningstar. “It would have to be an astonishingly bad market for your investment to be worth less than what you put in if you had invested for several decades. The longest bear market we've typically had has lasted only a few years.” The death benefit might make more sense if you knew you were going to die within five years, and you thought the market was headed for bear territory.
The same logic makes equity-linked products, while psychologically reassuring, not necessarily worth the extra cost. “What happens with equity-linked products is you trade away some upside growth for downside protection, which is short term,” says Larry Elkin, founder of Palisades Hudson Management in White Plains, N.Y. “If we know you need to spend a certain amount of money within the next five years, you keep it out of stocks. If you can tie it up for longer, you have the ultimate equity-linked investment — it's called equity.”
As for sign-up bonuses and matches, there's no free lunch. Insurers are likely to recoup those bonuses through fees over time. “I don't like contracts that pay huge bonuses upfront to clients. There's not enough room for everyone to make money,” says Norman Chiodras, head of Retirement Planners Inc. in Oak Brook, Ill. “Often the client really gets a below-market rate. So brokers will only have a happy client for one year.”
That said, one could boil down the attraction of annuities with the following rationale — a guaranteed income rider, 36 basis points; a sense of security, priceless.