Tue, 11 Dec 2012
Market trends have altered the benefits of several annuity products, and Morningstar's Kevin Loffredi examines what retirees should know before investing in these vehicles.
Christine Benz: Hi, I'm Christine Benz for Morningstar. When it comes to income, many investors naturally think of annuities, but they may be put off by the huge range of products and features. Joining me to discuss the annuity landscape is Kevin Loffredi. He is vice president of insurance solutions for Morningstar's software group.
Thank you, Kevin, for joining me.
Kevin Loffredi: You're welcome.
Benz: Kevin, let's start with the most basic type of annuity product, the single premium annuity. Let's discuss how that works.
Loffredi: Sure. So a single premium immediate annuity is the most simple annuity you can possibly come out with. In fact it goes back and dates back to the Roman times when you forfeit some money, you give money to an insurance company in this day and age, and they promise to pay you money every month or every year for the rest of your life. That's the most, simple explanation of what a single premium immediate annuity is.
Benz: So it's a simple and transparent product type?
Loffredi: Very simple. You know what you're going to get from the insurance company before you write that check to them. So there's no surprises. It's a single premium, so you're only writing one check to them. That's what that means, so it's very simple.
Benz: When you compare payouts on that type of product today versus what you would get with say, an intermediate-term Treasury bond or some sort of bond product, how do the two stack up, roughly? And I know it depends on your age and so forth, but [can you give] just a ballpark [explanation]?
Loffredi: Christine, as you say the age factors into it, so the older you are, the higher the guaranteed payment will be each and every year. So if you were to take someone who might be in their income year, somebody who is 70 years old, male or female, if they were to invest $100,000, they would receive about $500 a month for the rest of their life. That equates to about 6% per year. So that equates to something much more significant than you can get with the 10-year Treasury for example, which [has a yield] around 1.5% right now.
Benz: So the trade-off, though, is that it's close to an irreversible decision. You forked over your money and so you don't have that liquidity, you don't have access to that money anymore.
Loffredi: That's correct. That's been one of the hurdles; it's an irrevocable decision. So once you make that decision, you can't undo it. There are features now that some annuity carriers are providing that allow you to take withdrawals. Maybe you have an expense that you need to help a child out or maybe you have some health-care expenses that are large lump-sum payments. They allow you to go in there and take some of that money for a withdrawal to pay for that now in today's dollars. It may reduce the amount that you get in the future, but it's not as painful as it once was.
Benz: So you're getting that flexibility, but you are perhaps forsaking the higher payout that you would get if you simply went with the very basic annuity type?
Benz: It sounds like there has been some momentum behind income annuities. Recently investors have been sending dollars there. But payouts are pretty low relative to historic norms. Let's talk about how that works and why that is?
Loffredi: Sure. The rates that insurance companies can pay on an immediate annuity, is directly tied to what government bonds are paying. Essentially what they're doing behind the scenes is they're buying bonds and investing some of that money in different types of bonds, not always government bonds, but corporate bonds. But with rates so low right now, it directly impacts how much they can guarantee back to you. When you buy it today, you won't get as much today as you would have two years ago or two months ago for that matter. So, rates directly impact that.
Benz: Does that mean investors should wait then and wait until yields go back up, and then think about buying this sort of product?
Loffredi: Well, I would say it wouldn't make sense to take all of your money that you would kind of earmark for this type of investment. I wouldn't put it all in right now. Just like you would dollar-cost average into the stock market, you could take that same kind of philosophy and apply it to allocating monies to these immediate annuities.
Benz: Do sort of a laddered approach to annuities?
Loffredi: Yes. It might be a little inconvenient; you might get more checks or more direct deposits than you would have originally anticipated. The likelihood is that rates are going to go up before they go down. There is not much more room for them to go down, so it wouldn't make sense to put a lot of money into it right now.
Benz: Let's switch gears and discuss variable products. They give you more flexibility than you have with the income-only annuity. You are in charge of what investments you're in. Let's discuss the key features of variable annuities and how they are different from the very basic income annuities that we just discussed?
Loffredi: The single premium immediate annuity, which is really for income now, is not tax-deferred. So you're going to be getting money coming out of that right away. One benefit that we didn't talk about is that there is an exclusion ratio that you get applied to those income dollars. So it's not all treated as income for tax purposes. Some of it is treated as a return of principal.
Compare that to the variable annuity, which really we're talking about the tax-deferred variable annuity. So this is for money where you're not taking money necessarily, or for investments that you're not taking dollars out right away, it's for those dollars where you want to grow them tax-deferred. But there is a point where you may say, "I want to buy it and I want income at the same time."
If you did that with the variable annuity, a lot of the annuities have what are called living benefits attached to them; guaranteed lifetime withdrawal benefits, guaranteed minimum income benefits. In essence what those do is, those provide a floor that says no matter what happens to the investments inside there, if they go down in value, the guaranties that the company has put on there, will provide an income stream that you cannot outlive, which is very similar to the income annuity of the single premium immediate annuity.
Benz: Let's discuss some of the trends in those products. My understanding is that during the financial crisis, a lot of insurers realized, "We are probably underpricing some of these protections that we are giving purchasers of these products." How has that landscape changed since the financial crisis, and then in general, would you say that products are a little less generous than perhaps they were in the past?
Loffredi: Yes, I think, overall, they are a little bit less generous. They are also little bit more expensive than where they used to be before.
Benz: And they weren't cheap before.
Loffredi: They weren't. Back in the 1990s, you could buy a living benefit for 0.25% per year. That same type of benefit costs now 1% per year. So, you could say, back in the '90s, they were really inexpensive. They've made them a little bit more expensive. They have made them a little bit less impactful in terms of the withdrawals, so they might not offer 6% withdrawals for life now. Now, it's more like 5%. You might still find 5.25%. And again, some of those living benefits are tied to your age, so the older you are, the more you get rewarded in terms of the withdrawal percentage. There are still some attractive ones out there.
What we've seen also is a paring back in terms of how risky you can invest those dollars that are in the variable annuity with that living benefit wrap around there. So, in the old days, they used to allow you to go into 100% technology if you wanted to, no restrictions on how you invested your money.
Nowadays, they've put kind of like guardrails on how you invest those dollars. They might only say you can only go 65% in equity and 35% in kind of fixed income. We want to make sure that you have a nice balance. You should invest like everybody else should invest. We don't want you to kind of take extra risk and put us on the hook for paying you that lifetime withdrawal benefit. So those guardrails have gone from 90% equities and 10% fixed income to 80% to 70%, and you can still find some that don't have restrictions, but there are very few and far between.
Benz: One thing I often hear from people, even people who already own variable annuities, is they're not sure what they have. They are not even sure that they have variable annuities. So, it's obviously a confusing landscape and I'm wondering, if you can offer some advice to people attempting to make sense of an annuity purchase? What are the key factors they should focus on when they are trying to decide if such a product is a good fit for them?
Loffredi: That's a great question, and I've got a lot of things going on in terms of like what things you should ask. I look at variable annuities from how they're structured. So, how do you have it titled? Did you have it titled properly? Is it going to provide the income that you are looking for? Do you have somebody who you are working with who can properly explain not just the bells and whistles, but how does it really work? How are certain situations going to impact me? What if I need to take an excess withdrawal? I'm only allowed to take out 5%. But what happens if I take 7% one year because I need a little extra?
You need someone who you work with--and it doesn't have to be a broker, it could be a direct-sold contract from a carrier--but you need to work with someone who understands how it works. You need to be comfortable with it, and it needs to provide what you're looking for. Some people are buying these lifetime withdrawal benefits, but they are not even drawing the income out of it yet or don't anticipate drawing income from there. So, they might be paying an expensive fee for something that might not even be applicable for them.
Benz: You've mentioned fees a couple of times, Kevin. Let's talk about the overall cost loads of some of these products. What's a reasonable range or what's the general all-in cost of a variable annuity on maybe a per-year basis?
Loffredi: When you look at the total cost of a variable annuity, there are really three components to it. The first component is really just the base contract expense. Kind of think of it like the infrastructure expense of having that benefit or that investment available. That generally costs about 130 basis points per year, so 1.3% per year.
You add on top of that the subaccounts that are inside of that annuity. Subaccounts are akin to mutual funds, and you have a wide variety of types of the subaccounts that you can have in there. But the average fee is about 1% per year.
And then you add on if you want a living benefit that's going to provide you guaranteed income for life with upside potential but downside protection, those benefits cost about 1%, as well. So, you're talking about a little bit over 3% per year.
If you were to try to replicate that on your own by buying an option strategy to kind of collar the risk that's there and provide income to you, I have seen studies where it could cost over 5% per year in transaction costs. So, there are some economies of scale that the insurance company is able to get even though it seems like an expensive proposition.
Benz: Well, Kevin obviously, there is a lot of meat on this topic, many different wrinkles to discuss in the variable annuity space, but we very much appreciate you being here to just help people navigate a very complicated space.
Loffredi: Well, you're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.