Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors who own annuities don't always know what they own. Joining me to discuss some of the key pitfalls confronting annuity owners is Mark Cortazzo.
Mark, thank you so much for being here.
Mark Cortazzo: It's a pleasure.
Benz: Annuities are among the most complicated financial products. I think a lot of consumers are really confounded when they try to analyze either an annuity they're thinking about purchasing or maybe even one they already have. You say, the current landscape and the types of products that are being issued today are actually pretty conservative; insurers are really trying to protect themselves. Let's talk about what you mean by that.
Cortazzo: Some of the legacy contracts, ones issued prior to '08. We had a higher interest-rate environment; money markets were paying 4.5%, 5%. So risk-free rates of return were higher, and the perception of risk was very different prior to 2008 occurring.
With the current products, the insurance companies have dialed up costs and made investment restrictions greater. And also the payouts are more conservative. What they're benchmarking against is also a lower rate of return, but that shift has been a pretty consistent one since the end of 2008.
Benz: Consumers may also be constrained in terms of their asset-allocation choices. Let's talk about what's going on there.
Cortazzo: Absolutely. There are only so many levers that you can pull to protect yourself if you're an insurance company. You can raise fees, and there is only so much threshold of pain people are going to take there. You can restrict how people can invest.
Some of the older contracts, ones that I even own, have no investment restrictions. So you could've put all of the money into a small-cap fund or into an international fund or be a 100% invested in equities. Many of the programs now may require 30%, 40%, I've seen as high as 50% of the portfolio to be in conservative fixed income, which is going to curtail your upside.
Some of the other things that they're able to do is use volatility restrictions. This is where as volatility in the equity markets increases, they can shift you to a more conservative mix reactively or even move significant pieces of the portfolio out of the market. They're trying to protect these against a severe downturn.
Benz: It may not be an attractive time to purchase some of these products. Your firm, Annuity Review, does an arm's length analysis of annuities, including products that someone might already own. I think it's a really valuable service and that a lot of people don't even know they own an annuity, let alone what features might be embedded inside it.
But you say that advisors should take a look at an annuity before selling it because some of the older contracts actually were pretty favorable for consumers.
Let's talk about the features that may have been there in the past. You mentioned higher interest rates, a higher fixed-rate option, as well as perhaps more asset-allocation flexibility. Are there any other things?
Cortazzo: The withdrawal rates were significantly higher. For a couple age 65 right now, the guaranteed withdrawal rates are about 4.5%. [Before 2008] you were able to get 6% or so, 33% higher withdrawal rate, and with no investment restrictions. So, you could be in an equity portfolio. We have accounts that did better than 30% last year because they were able to be fully invested in equities.
One of the little nitchy things that you wouldn't think to use the variable annuity for is many of the older variable annuities have fixed accounts in them. There are people who have completely liquid contracts and they may even own them in something like an IRA, which is counterintuitive owning a tax-deferred investment in a tax-deferred account.
But they might have a fixed account that when it was issued, had a contractual minimum guarantee of maybe 3%. When money markets were 5%, that was no big deal. Now with money markets less than a quarter of a percent, that 3% fixed bucket can be extremely valuable. And you can use it as a surrogate to the bond portion of your portfolio, which is paying a small fraction of that. So, there are some different ways to look at it.
Our firm has spent well over 20,000 hours doing research on these. We look at these differently, and we have a depth of knowledge. Some of these things jump out at us, but they might not be obvious to someone who's doing this the first time.
Benz: You've compiled a list of mistakes that you see. You've touched on some of them. One is just jettisoning that old annuity without really taking a look at what's in there, that there might be some attractive features. Another one is not setting it up correctly, not setting up beneficiary designations correctly. What mistake do people make in that area?
Cortazzo: If I can just touch on the jettisoning of other contracts. One more point on this is, many times someone will go to an advisor, and if they were fee-only advisor and don't understand these, their bias might be to get rid of them. Or if investors are talking to somebody who is trying to sell them something new, there is also very strong bias to get out of them. Even the conflict of information that people get when they go to a professional can be quite strong.
But in setting the contracts up incorrectly, we see ownership done wrong. For many of these contracts, if the primary owner passes away and they're married, their spouse can assume the contract and continue those guarantees as though they were the person who originally owned it. So, it's a spousal continuation or right to continue.
But they can only do that if they're the primary beneficiary of the annuity. What we see is for high-net-worth people who have these, they've gone and had estate planning done and the attorney drafted these very sophisticated trusts. And they're looking at all of their assets flowing into these trusts, and if the trust is the primary beneficiary, even though your spouse is the primary beneficiary of the trust, its semantics. The spouse isn't able to continue the guarantees because she's not the primary or he's not the primary beneficiary of it.
So, something simple as the beneficiary designation being nonspouse can disinherit the surviving spouse from being able to get that lifetime guaranteed income. The attorney isn't advising your investment planning and cash flow planning. He's advising on estate taxes, and what he did for estate tax purposes is valid. But it devastates the retirement planning. It's a very, very common mistake we see, and it's one that you wouldn't know it was wrong until it was too late.
Benz: Another way that you say people can kind of bungle their ownership of an annuity product is that they take extra withdrawals. Let's talk about that and what do you mean by extra withdrawals, first of all.
Cortazzo: Some of these contracts have an income guarantee. It's where you can draw 4% or 5% or 6%--if you have one of the richer contracts--a year for life. Let's say you can draw 5% a year for life. You have $100,000 in an annuity, and you're taking your $5,000 each year. Something comes up. You need some extra money for an event, and you take an extra $5,000 out of that contract, which is more than the guaranteed amount that you're allowed to take.
There are three different ways an insurance company can adjust for that. One of them is dollar for dollar, where the $5,000, now reduces your guarantee down to $95,000 from $100,000.
Some of them is pro rata or proportionately. So if my account value was $50,000 and my guarantee was $100,000, and I take an extra $5,000 out, it's 10% of my account value, so it would reduce your guarantee by 10%. So that $5,000 withdrawal reduces your guarantee by $10,000, so obviously not as attractive.
Then there is the killer one. If there is a big spread between your account value and your guarantee, some contracts reset your guarantee if you take an excess withdrawal. So that $5,000 extra that you needed reduces your guarantee from $100,000, all the way down to $50,000, and what that will do is your $5,000-a-year lifetime guaranteed income is now been reduced down to $2,500 a year for the rest of your life because you took an extra $5,000 out.
The devil is in the detail with these. They're contracts, and understanding the mechanics of them can really help you utilize them much better. Not understanding them can really hurt you without it being what you would expect.
Benz: Right. Another issue you say is that annuities do have some downside protection embedded into them, but people don't always utilize that protection even though of course they're paying for it. What is that mistake, and how can investors who own such products avoid it?
Cortazzo: The annuities are typically part of someone's portfolio, and it is something that has protection in it. We had a very intelligent multi-million-dollar portfolio person call and have us do a review for them. They had a seven-figure sum in an annuity and a seven-figure sum outside of the annuity, and the primary objective was income during retirement.
They had the annuity, which has guarantees on it, invested all in very, very conservative fixed income, and they had that money outside of the annuity in pretty aggressive mutual funds. [This person] had all of the upside but also had all of the downside, and the thing that would provide them protection in a downturn, they had it very conservatively invested.
So understanding why you own these, where they work well, and how to utilize them better, just flip-flopping where they owned what they owned, didn't change their expected rate of return from an upside perspective by very much at all. But the downside protection that is provided [in an annuity], if we get a retrenchment in the market, is they're doing the risky trick on the trapeze that has a safety net versus the one that doesn't have it.
Since these are so complicated, and many times they are sold and the advisors don't have ongoing servicing and support on it, someone gets lost in why they bought it and how it works. And so they just default to [the simple solution] and underutilize the value of these tremendously.
Benz: It's really kind of a different spin on that asset-location question.
Cortazzo: Absolutely. There is only so many things you can control in the process. You can control your overall allocation. You can control where you own, what you own, and costs to a large degree. And when you're focusing on risk, you can avoid it. You can manage it. You can transfer it.
[An annuity] is a risk-transfer vehicle, and so if you're going to use that and pay for risk transfer, if you're going to have a little bit more equity exposure in the portfolio, that's a great place to have it. It is something that somebody who might typically only have a 50-50 mix of stocks to bonds may be able to get to 60% or 70% equity exposure if that incremental amount isn't something that has protection.
Benz: Downside protection.
Benz: Well, Mark, thank you so much for being here. This is a really complicated area, and it was great to hear about some of the pitfalls that annuity owners sometimes run into.
Cortazzo: Well, it was a pleasure chatting with you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.