Why Annuities Are a Bad Idea

The following is a guest post from Retirement Savior. I've recently covered annuities and wanted to do so again since any post on this topic seems to bring out a great debate on the subject. :-)

Summary: Are you sure that your investments will return greater than a lowly 3-4% over the long run?  If so, the guarantee of an annuity is probably more comforting mentally than financially.

A recent WSJ article had me thinking about annuities and risk avoidance. Because of the crisis, investors have had a huge interest in annuities both variable and fixed.   They are high-fee products that have been on the defensive in recent years, and justifiably so.

Fixed annuities are contracts that pay you a fixed amount based on a percentage of your principal investment for the rest of your life.  Variable annuities are basically a set of mutual funds sold by the insurance company where an investor accumulates investments over a period of time, in return for a percentage payout later on that can grow over time for the rest of the beneficiary's life.  They usually come with a minimum payment to compensate for any bad investments.  These products typically have high fees (1.33% average annual expenses according to 2009 Morningstar data, in addition to the investment fund expenses).

Investors feel more comfortable with these contracts because of the limited downside, but they do not have an understanding of the nuts and bolts of the issue. If the annuity company pays out 5% a year on the principal, then for an investor to believe that they are getting the better side of the deal, they must assume that they would not be able to invest the money on their own and take 5% withdrawals without the portfolio running out during their lifetime. If the average annuity fee is 2% per year after mutual fund expenses, this should be quite an easy target to beat. Take a minute and if you can beat a typical variable annuity:

• $100,000 accumulation investment, to begin payouts at age 60.
• 5% annual payout starting at age 60, with 3% payout increase per year from investment growth.
• Death at age 90.

The total payout over the 30 years in the above scenario is $250,013.39.

Imagine you invested $100,000 on your own. To get the same performance as the annuity above with the same payouts, you would need to have a 2.84% annual return net of fees.  Do you think you can get those returns after fees?  I thought so.  In fact, there should be no reason that a diversified, well planned portfolio shouldn't more than double those returns after fees.

You might say that I have made an unfair example, and that variable annuities can have much higher returns with investments in stocks.  I would disagree.  Consider that the fees (around 2% per year) are so much higher than you would have with ETFs, or that annuity withdrawals are taxed at ordinary income rates instead of long term capital gains rates.

Do not be fearful about your retirement savings, because with a well structured and disciplined investment plan, you can disregard annuities and make more money on your own.

Comments

[Jason @ Redeeming Riches]

I hate to disagree with Retirement Savior, but this is the same argument made over and over regarding annuities - high fees.

By the way, fixed annuities rarely, if ever, have fees. They are essentially a glorified CD (with tax differences for non-IRA accounts). You get a set return for a period of time. You wouldn't compare a CD to an S&P500 ETF, so the comparison to a fixed annuity is not apples to apples.

If variable annuities are bought strictly for investment performance than yes, I understand you would probably want to do your proposed ETF strategy.

However, annuities are the only place you can use a Guaranteed Living Benefit that locks in your gains so that the amount of your withdrawal is based on the highest amount you've locked in, not just the amount of your principal or on your account value.

You can also get guaranteed income for life from these things.

People who had this feature before the crash of '08 are feeling pretty good right now.

My point is: No one investment is ever right for everyone, nor is one investment always bad. I don't think you should throw all of your money into these things, but for a portion and depending on your situation it MIGHT make sense.

The more important question is WHY you are using a particular product and if you understand the key differences and make an informed decision then it can help.

[MJP]

More stock market investment hype from someone who works in the business, and a managed fund advocate at that. I'm not necessarily a fan of annuities (because most are not indexed to inflation) but the argument that a "well diversified, planned portfolio" will protect you from a market crash was quickly disproved in 2008 when virtually every asset class tanked. It can and will happen again. Secure your basic retirement income needs with Social Security, TIPS and I-Bonds. Use the rest of your money to risk with folks like this author if you wish.

[Edmund]

Maybe I'm doing the math wrong. Somebody please check my math:

"Imagine you invested $100,000 on your own. To get the same performance as the annuity above with the same payouts, you would need to have a 2.84% annual return net of fees."

It seems like to me that if you want to invest in $100k, and get $250,013.39, you would need 3.1016089% annual return. Where does 2.84% come from?

That's not all. The above math assumes that the $250,013.39 is paid out at the end of 30 years. The fact that you start drawing money out immediately means you are going to need much higher return to withdraw total of $250,013.39 over 30 years.

I don't know about you, but I wouldn't trust "5% annual payout starting at age 60, with 3% payout increase per year from investment growth" with my own investment.

(I thought the rule was to draw no more than 4%)

[Sarah]

I've always understood that fixed annuities don't have annual fees. You purchase them for an up-front sum.

I wouldn't want to base my entire income on a fixed annuity, but considering the older you get, the less margin you have for error--the greater the chances you won't be able to seek out supplementary income or even invest much time in managing your investments--the more of a premium you should be willing to pay for security.

I wouldn't want to be 80, frail, and facing a portfolio that had just dumped 35% of its value.

[Brad Castro]

Well, I'm an equal opportunity hater here - I think annuities and mutual funds are both poor choices.

With an annuity, I pay someone to take my money and provide me a very modest allowance.

And with mutual funds, I pay someone to take my money and over trade and under perform the market on my behalf.

I'll take my chances with a long term, concentrated portfolio of the best individual companies I can identify.

Long term investors who purchased shares of McDonald's back in 1992 are now receiving a dividend yield in excess of 25%.

How's that for an annuity?

[Kirk Kinder]

There are two parties who are guaranteed to make money with annuities: the insurance company and the salesman. Outside that, I have seen annuities fail investors more than help them.

Granted there is market risk if you invest on your own, but I don't know why an 85 year old would lose 35% of their portfolio. They should be no where near that aggressive in a portfolio.

Also, this guaranteed payout is only as good as the party providing the payout. If the insurance company fails, so does the annuity. Many say this won't happen as state regulators monitor the insurance companies, but we have see how lax regulation happens all too frequently.

[Sarah]

It's my understanding that fixed annuities are government-insured for up to $100K of principal.

Long-term investors who bought Enron before the bankruptcy are now receiving...nothing, Brad Castro. Trusting your retirement to a task that most professionals do too poorly to justify their paychecks strikes me as a risky business. But, of course, it's a well-known characteristic of people who aren't skilled at something to overestimate their ability to do it.

[Brad Castro]

To clarify, Sarah, I said: "a long term, concentrated portfolio of the best individual companies I can identify." I didn't say: "a long term, concentrated portfolio of the WORST individual companies I can identify."

Whenever I make the point that investing actually entails investing (owning pieces of real, high quality, long term dominant businesses that you've carefully and methodically researched) someone invariably throws out an Enron or GM reference, as though any large, bloated, unsustainable company with a recognizable brand is all we buy and hold simpletons are looking for.

Identifying a superior business really isn't that hard if you're willing to invest a little time and thought upfront. My God, just take a leisurely month and read Warren Buffett's annual shareholder letters archived on the Berkshire Hathaway website and you'll be way ahead of just about everyone else.

Investing works.

But if you can't tell the difference between McDonald's and Enron, Sarah, or aren't interested in telling the difference, then, yes, I'd agree - you have no business investing and you're undoubtedly better off putting your savings into a CD or an annuity where it's likely that you'll at least retain your principal - that is until you burn through it all during your declining retirement years.

[Sarah]

If identifying the superior businesses were something that was easy to do, Brad, more people would be doing it. The fact that most professional mutual fund managers can't outperform the market should give you serious pause. Buffett himself doesn't recommend individual stock-picking for individual investors. Enron was the absolute darling of the financial press and stock analysts--until it wasn't. It's child's play to tell the difference between McDonald's and Enron...in hindsight.

[Brad Castro]

"If identifying the superior businesses were something that was easy to do, Brad, more people would be doing it."

I didn't say it was easy, Sarah, I said it wasn't that hard if you were willing to put forth some effort. If you want average results, keep making average decisions.

----

"The fact that most professional mutual fund managers can't outperform the market should give you serious pause."

And why can't they outperform the market?

1. They have way too much money to manage

2. They're forced to overdiversify and end up owning as many (or even more) mediocre companies as truly great ones

3. Their job security is based on quarterly performance, not on building wealth long term.

4. As such, they must attempt to time the market.

5. Timing the market isn't investing - it's trading, and trading is very difficult, especially when you've got tens and hundreds of millions of dollars under management.

5. Timing the market also doesn't work - the reason it's so difficult is that what you're really attempting to predict isn't the future prospects of a business, but rather the future short term behavior of other traders.

6. It isn't their money - they get paid from the fees collected. Performance doesn't matter - as long as it's acceptably mediocre, they'll keep their jobs.

----

"Enron was the absolute darling of the financial press and stock analysts--until it wasn't."

Again, popularity isn't the same as quality. Enron was a trading-based house of cards operation. That it was a house of cards wasn't obvious beforehand, I'll admit.

But no serious investor who looked at the business model and the complexity of the balance sheet came away saying, "Wow, what a terrific business model with little down side risks. And I'm just enamored by all the debt they're carrying. That shows real confidence. I better buy as many shares as I possibly can."

[Apex]

Edmund,

You are exactly right on both points. I noticed that too and it really bothers me that these kinds of mistakes which drastically alter the argument are allowed to be made and go unchecked and unchallenged.

So I did a little test. I created a spreadsheet that starts with 100K and withdrew 5% upfront with 3% increase per year until age 90 (it's actually 31 withdrawals) (granted it would probably be done monthly but this gets you close). Then I determined what percent return one would need to make it to age 90.

This is likely the exact calculation that the author used because my total withdrawals using this method were 250,013.40 (1 penny more than he listed probably due to rounding).

And what percent return did it take to get there? 6.17%. It's easy to create this spreadhsheet and anyone who understands compounding and withdrawals could do it. The idea of comparing annual or monthly withdrawals with a compounding rate that never withdraws any money is the most basic financial mistake that anyone who would make it really has no credibility as far as giving financial advice.

I am neither an advocate for or against annuities. But the math used as justification for this author's view is so blatantly wrong that it is frankly disgusting that his argument is allowed to be posted. The 6.17% return that gives the results this author is mocking are actually quite good. Whether they are the way a real annuity would work or not I don't know, but these are the Author's numbers. He just can't do math and is definitely not smarter than a 5th grader.

[Kevin Jackson]

The truth as anyone really in the business knows is that the numbers may be skewed in any shape or fashion to make one investment seemingly perform better than another. What many in the securities business always fail to consider is that there are many ways of using annuities for both income and growth. Most qualified financial advisors using annuity strategies can almost always construct a solution that provides growth and income and guarantees that will almost always mirror market growth without the market risk.

Securities sales have always been market timed gambles using meaningless historical figures as a predictor of future performance although every prospect advises against this. But since there are no guarantees and no one truly knows the future, this is the only argument they can make. Unfortunately for the securities industry, with current technology, future market swings will likely occur even more often than before - meaning that market movement and the associated gains and losses with it will prove to be even more volatile in the future. For those who are young or who have substantial assets, then go for it - you have time to correct your mistakes or can afford the loss. But like any good business man worth his salt will tell you, don't ever risk what you can't afford to lose.

Securities folks will try to correct this problem with proper asset allocation, but the reality is that the vast majority of senior clients were NOT allocated correctly over the last two decades. Although at times they saw huge gains from market bubbles, over the long term almost all of them have seen significant losses. I'm amazed at how many of these folks were jumping off of bridges 9 months ago and now they're all excited because we've seen a small market rebound. Reality check - the market is still off by huge numbers. Only mutual fund sales men could get excited about a product that has provided their clients with 20-30% losses over the last year and even try to use this as evidence their clients should invest even more. It's almost laughable if it weren't true.

I talk to client after client in retirement who have recognized HUGE LOSSES. And they were working with "advisors". So gentlemen who write articles like this can make valid arguments mathematically and on paper, but anyone who is truly in the field working with senior can attest to the fact that these kinds of strategies are simply not in play for the vast majority. And for these non-high-net-worth folks, guaranteed annuity strategies simply cannot be beat. One thing is for sure - I talk to hundreds of folks every month and without a doubt, the happiest and most secure clients are those with guaranteed annuity solutions.

Let me assure all reading this that I am not against equities, in fact I do believe they have their place. But I do believe they are truly over sold and presented to the vast majority as unsuitable investments. And the vast market wealth that has evaporated over the last over the last only proves this out.

The bottom line? If you want to gamble, go to Vegas. If you want to secure your retirement and sleep well, create a plan that insures lifetime income along with future growth in such a way that is practical and secure. Even if you have significant assets, diversifying with annuities is an excellent idea.

After all, since when did safety, security, peace of mind and a good nights sleep become a "bad idea"?

Kevin W. Jackson

[Jim]

I'm not so much a fan of variable annuities but I do think that fixed annuities have a place in retirement. Variable annuities do often have high fees and sales commissions. I'd avoid those and buy a straight forward fixed annuity instead.

The key benefit of a fixed annuity is that it gives GUARANTEED lifetime income. That is a very good benefit for retirement planning as it removes risk and uncertainty.

Sure you can throw your money in the stock market, withdraw 4% annually and *probably* come out ahead in 20-30 years compared to an annuity. But the key word there is *probably*. What if you live to 100? What if inflation is higher? What if your investments don't do as well as expected?

[Evolution Of Wealth]

Edmund, I did the same thing as you did as soon as I read this post. I knew the math wasn't right. I also came up with 6.17%. That's a pretty big difference to me, needed over 6% vs under 3%.
I think even scarier than the poor math is the message this post is sending. Someone could easily read this as 'I can withdraw 5% per year from my investment account, indexed for inflation and be great after 30 years'. Haven't enough studies shown that you can not make this statement? Hasn't 2008 taught us anything?
I think enough people have made the comment that they work in the right situation but they are not the end all be all. The truth is also that any investment or even a great investment plan is not the end all be all. Nothing is, everyone is different.

[Retirement Savior]

@Edmund, Apex and Evolution of Wealth

You are all right. The original analysis was just plain wrong. Until EoW commented I did not go back and see if your math was correct. Whether or not the words "frankly disgusting" are warranted is not my call, but the error was certainly egregious.

I apologize and know that this post removes any credibility I have with you guys, but I will let the merits of my other posts stand for themselves.

And thanks for correcting me, not only for giving me a dose of humility and for the benefit of the readers, but for making blogs a more credible place with real-time feedback and commentary.

RS

[Dave]

Getting 10% on my annuity. Can't expect that in the market with any certainty. Looks like a good deal to me.