Annuities: Questions to Ask and Mistakes to Avoid

Morningstar recently sat down with certified financial planner Mark Cortazzo, a senior partner at MACRO Consulting Group. He detailed how annuities can help some retirees manage their longevity risk or ensure coverage of necessary expenses, but investors should assess the costs, benefits, and alternatives before buying. He also addressed how those who are already invested in annuities must take care to fully understand their contracts before letting multiple obstacles diminish their income potential.

Ask These Key Questions About Annuities 
Question: You brought some data showing that consumers really don't understand annuities. In fact, one statistic you had was that 44% of consumers rate themselves either a D or an F in terms of their knowledge of annuities. So, people really are oftentimes baffled by these products. They are complicated; it can really be difficult to know what you own or how to purchase one or even what questions to ask.

There are key questions to ask if you are talking to an advisor who is encouraging you to buy an annuity product. Maybe we can run through some of the ways that you might be a savvy consumer.

Let's start with a big one, which is, what is the benefit of this product versus just a vanilla portfolio that doesn't include any insurance protection?

Mark Cortazzo: The number one concern for people three to five years from retiring is running out of money during their retirement. And for most people with a diversified portfolio, that's not going to be a problem. But for some percentage of them, depending on the timing of when they started taking their withdrawals and what their allocation is, there might be an 8%, 10%, 12%, or 15% chance of running out of money during retirement.

What you can do is pool that risk. By transferring risk, which is what annuities do, you are pooling that risk, so if you are the unlucky one that might be in that 8%, 10%, 12%, or 15% band, this protects you from not having a paycheck during your lifetime. Think about it like your homeowners insurance. We all chip in our $800 or $1,000 a year into the pot. For most people, it's a terrible investment. They're going to get zero return on that. But I live in New Jersey, and when Superstorm Sandy hit, it was the best investment that many people had ever made in their lives because houses were wiped out.

When you're transferring risk, and you're using insurance, you do that on things that aren't likely events to occur, but that if they occur, are financially devastating. If they're likely to happen, it's too expensive to insure, and it has to have a big impact on you--which running out of money during your retirement does. So, annuities transfer that longevity risk, that income risk.

We are paying an extra fee, and there could be additional complexity with it, but it's a trade-off. And it's something we hope you're never going to use, and it's also not likely that you are going to use it. But if you retired in 2000 right at the beginning of a downturn and were withdrawing from your portfolio with a broad basket of stocks, right now you are almost already out of money. So, those are the things that we're trying to protect people from, and you pool that risk. That's where we think it fits.

Q: Does everyone need a product like this with guarantees?

Cortazzo: No.

Q: What types of people can say, "No, I don't need that type of protection?"

Cortazzo: The annuity does a couple of things. It can provide you with enough to cover your "needs" expenses, and then you can invest the rest in lower-cost investments to complement that for your "wants." But at least you know that your basic expenses are covered. If, between pension, Social Security, and some type of guaranteed paycheck, my needs are covered, then I can sleep at night, and if I don't get to take a vacation this year because the market was down, I can live with that. If I can't pay my property tax or buy food, that's something that becomes difficult. Sometimes in pursuit of someone's wants, they sacrifice securing their needs. This is where annuities can fit in.

For somebody who has a very low withdrawal rate and can assume the risk of the market or can hedge this in some other way, [an annuity is] not necessary. If your house got destroyed and you have enough resources to rebuild it without having a big impact, maybe you don't need homeowners insurance.

So, it's something that you have to look at: What's the probability of this happening? What's the downside if it happens? And do I have options to be able to absorb that? It's like any other insurance decision.

Q: Another key question is the cost of this thing. Annuities have many layers of costs that can be really difficult to get your arms around. If consumers are trying to be smart about this, what are the best data points that they want to look at to try to get their arms around the all-in costs of owning an annuity?

Cortazzo: If you're owning a variable annuity with an income guarantee, which is where most of the new investments in these are are going because it does provide this unique protection, it has upside tied to the equity markets, and it has a level of protection that sits below it.

But the costs on it are going to be the internal costs. The mortality and expense charge is what the technical internal costs are. That's how the insurance company makes their money, and it's how the advisor is getting paid.

Then there's the cost of the underlying investments that you're in--the subaccounts. So they could be indexes and very low-cost; they could be active managers with a little bit higher cost. And they're trying to outperform the market.

Then there's going to be the cost for the protection, and that rider fee is typically a separate cost. Most of the time, it's assessed against the guaranteed amount. They are charging the insurance cost against the number that they're insuring. So if your guarantee has some type of growth rate on it, that cost is going to be increasing. Understanding what those internal costs are and how they are being assessed--if they're assessed against the account value as a percentage or against the guarantee as a percentage--can also have an impact on the drag on the portfolio.

But if you owned a house for 30 years, and you didn't have homeowners insurance, you would have a higher rate of return on that real estate. If you never had a fire or flood, that was a smart move. So it is a cost, and you are getting protection for it. You've got to weigh whether the value of that protection is worth the cost.

Q: You note that another question people should ask when evaluating some sort of an annuity product is, what sort of supplemental protection does it provide? Can you go into detail about this, and what are people looking for when they're trying to evaluate that?

Cortazzo: The two most common would be some type of income guarantee and some type of death benefit.

The income guarantee is something that provides you, or perhaps you and your spouse, protection of income for the rest of your life. An example might be that you invest a set dollar amount and you can invest in the equity markets, but they will guarantee you 5% a year for life off of that value.

So even if the market gets hit and you're drawing from it and the account runs out of money, and one of you lives to 100, if you ran out of money at age 80, they keep paying you this $5,000 a year for 20 more years. That's the additional cost that everyone is paying, it's to pay that person who ran out of money--that $5,000 a year is coming from somewhere. It's from that pot that everybody is chipping into.

If your account value does well--your $100,000 goes to $120,000 and then $130,000 and then $150,000 during the next five years--some annuity providers will reset that guarantee, and now you're getting 5% of $150,000. And if the market has a big downturn again, it drops below where you originally started--it goes from $150,000 all the way back down to $90,000--you keep getting 5% a year for life off of that high anniversary value hit in year 5, and it becomes a permanent raise.

It's has equity feel and exposure to it, but the protection is dynamic. If I owned a mutual fund that went from $100,000 to $150,000 and now back down to $90,000, I've got a $10,000 loss and a lot of remorse for not getting out at $150,000.

You've actually captured some economic value by that account hitting that peak at some point that changes your cash flow for the rest of your life. So, there are some really unique things about this that nothing else can replicate, and obviously that's a big difference for the insurance company. There is going to be a cost for them to assume that risk.

Q: The spousal protection carries a cost, too, right? You can't just add that without paying more?

Cortazzo: Well, it's interesting. On some of the legacy contracts, spousal protection was baked into it, and it was something that the issuers were just able to continue. So, many of the contracts issued before 2009 have this spousal continuation as a default, and it wasn't additional.

For the newer contracts, it was an option that people had to choose, and it was either single life or joint life. These contracts will do one of two things--either charge more for the joint or it may be a lower withdrawal rate. If it's 5% for a single, it might be 4.5% for a joint, and it's the same cost.

The insurance companies have different levers they can pull with this. They can modify what you can invest in, they can modify cost, and they can modify the withdrawal rates. Those are all levers.

Comparing and contrasting these does get a bit complicated, and what we tend to find is someone is presented one product. Somebody might know that one well, they might work for that company, and that's the solution. But I really think it's something that you should shop out. Ask other people. Get an independent analysis because it can be a significant difference.

Q: You've hinted, Mark, that incentives can skew the decision-making. The person presenting you with this product may have a vested interest in getting you to choose the more expensive one. How can you direct the outcome so that you are in fact being shown the full suite of products rather than just the one that pays the salesperson the best?

Cortazzo: I think you can ask that question. You can ask them to provide you an answer of that in writing. One of the other things that you can do is talk to more than one person. ​

Avoid These Annuity Mistakes
Q: Shifting gears, annuities are among the most complicated financial products. Many consumers are really confounded when they try to analyze either an annuity they're thinking about purchasing or 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: For some of the legacy contracts, ones issued prior to 2008, we had a higher interest-rate environment. Money markets were paying 4.5%-5.0%. 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. 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.

Q: 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.

Q: 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, a 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 offering 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 more than 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.

Q: 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 a 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. When professionals set up 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--it's 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 was wrong until it was too late.

Q: 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 were $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%. 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 use them much better. Not understanding them can really hurt you without it being what you would expect.

Q: 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.

Q: It's really a different spin on that asset-location question.

Cortazzo: Absolutely. There are 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 and bonds may be able to get to 60% or 70% equity exposure if that incremental amount isn't something that has downside protection.