Annuities: More Insurance Than Investment

Christine Benz: Hi,I'm Christine Benz for Morningstar.com. Many investors reflexively steer away from annuities--but should they? Joining me to discuss that topic is David Blanchett--he is head of retirement research for Morningstar Investment Management.

David, thank you so much being here.

David Blanchett: Thanks for having me.

Benz: David, I know that a lot of our Morningstar.com readers are sort of reflexively averse to annuities, and there are arguably some good reasons for being so--you've got the high cost and you also have that psychological impediment of giving away a portion of your portfolio that you'll never get back. Let's discuss, though, what annuities can do for your retirement plan that traditional investment vehicles cannot give you.

Blanchett: Annuities--when you say the word, people kind of instantly react. I would say that an annuity is not an investment; it's a risk-management tool. People buy life insurance all the time; people buy car insurance, health insurance. An annuity is a form of insurance. You buy it to protect yourself against the possibility of outliving your resources. Like any form of insurance, it can be expensive, and it can be cheap. There are different types. So, I think the kind of person who would value an annuity is someone who says, "I may live longer than average, and I want that guarantee that--no matter what--I've got something to live off of."

Benz: So, that's a commonality among all annuity types?

Blanchett: It really is. The benefit of the annuity, really, is that it will help someone who is going to live longer than average. It's kind of like claiming Social Security: The longer you live, the more you benefit from owning it. Now, that being said, someone who even has a lower-than-average life expectancy may still want to buy just because they want that certainty. How much do you value the certainty of knowing that, no matter how long you live, you have some kind of income for life?

Benz: And, of course, that certainty would probably be less valuable if you had a lot of other certain sources of income coming in the door in retirement, right?

Blanchett: That's right. I run all of these different models thinking about who should buy an annuity, and the most important factor in this model is, what is your existing level of guaranteed income? The average retiree household gets about 40% of their income from Social Security. For other households, it's more or less. The more you have in Social Security and pensions, the less valuable an annuity is going to be.

Benz: Let's talk about some of the key annuity types. The most basic plain-vanilla annuity type is the immediate annuity: You give the insurer some of your money, and they send it back to you as a stream of income. Let's discuss the pros and cons of such a product.

Blanchett: Those have been around now for thousands of years. They used to be the most common. They are still quite common. I think it's the most intuitive type of annuity--it's an immediate effective transfer. You give away the money, and you get money for life. So, these can be somewhat scary. Most of those annuities sold actually include what's called a 10-year period certain. You are guaranteed a benefit payment for at least 10 years. I think that these makes sense for someone who says, "I don't want to do this." If you are working with a financial planner, they can help you figure out what the right spending amount from a portfolio is. These [annuities] simplify things radically. I think these are more and more valuable for older and older retirees. As you move through retirement, you might say, "I don't want to be portfolio manager; I don't want to figure out what I should spend from my portfolio, so I'm going to annuitize as I age over time."

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Benz: But it seems that the more protections you layer on for yourself with such a product--for example, if you want a spousal benefit to be there--the less rich your payouts will be, correct?

Blanchett: Correct. It's all based upon actuarial science. If you add on a second party, it's going to decrease your benefit. One benefit I'm not a huge fan of today is inflation riders. They provide a guaranteed increase with inflationary every year. Most companies don't offer them, so it's a somewhat illiquid market. And while it is valuable to know that your benefits increase for inflation, you're probably better off just having a guaranteed step up. So, you get a policy where the benefit increases every year by 2%--that way, you take on the inflation risk, and you actually get a higher net payout on average.

Benz: Before we move on to the other annuity types, let's talk about how the interest-rate environment affects the payments that you'd receive from an annuity.

Blanchett: There are two main factors that come into play when figuring out what your payment is going to be from an annuity. The first is the market interest-rate environment, and the second is mortality. So, if you buy an annuity when you're 50 years old, you really are affected by buying it at that age. Think of it as being a long-term bond--a very low rate today. I think that there is some apprehension from a lot of individual investors out there wondering whether they should annuitize. I think that one perspective is that you should probably dollar-cost average--maybe buy it slowly. But the younger you are, the more you are affected by this low-interest-rate environment.

Benz: So, if you can wait, maybe you should think about it.

Blanchett: As you age, though, you accrue what are called mortality credits. And that's just a way to say that people who have already passed away subsidize those who live a long time. So, I wouldn't forgo the entire decision; I would say to maybe go slowly and buy a little bit over time.

Benz: The next annuity type I want to talk about is the deferred income annuity. Let's talk about how that's different from the immediate annuities that we just talked about.

Blanchett: These are often called longevity insurance, and these are different in that immediate annuity provides instant money. So, you give the insurance company $100,000, and they write you a check next month for, say, $6,000 a year, total, divided by 12. [But for deferred income annuities,] you only receive income if you survive to a given age. The classic example is that I retire at age 65, and I then write a check for $100,000 to, say, MetLife--an insurance provider of these products. Then, once I live to age 85--and every year thereafter--I receive a guaranteed benefit for life. So, they are a lot less expensive than immediate annuities, but I have to survive to a given age, and then how long I live determines the payout.

Now, there are return-of-premium features you can add on to that, but it really is a more pure way to hedge out longevity risk because, for most retirees, they're not afraid of living till tomorrow, it's living past, say, age 80 or 90 where their assets may not be able to provide for them for the rest of their life.

Benz: Some changes in regulations in the past year have made these products a lot more prevalent. Let's talk about those changes and why they may be under consideration for more retirees than they were in the past.

Blanchett: So, there were two guidances that were released last year from the Treasury talking about deferred income annuities or longevity insurance. One of them was focused on using them in, say, IRAs or 401(k)s past RMDs--so allowing investors to hold them in an account and not taking RMDs from them. So, I think that they really can be attractive as a means to annuitize part of your nest egg. There are restrictions on how much you can have, based upon both dollar as well as account percentage; however, it makes a lot of sense. I think that for someone who wants to hedge off that risk, that's a natural place to look for them.

Benz: So, is that the kind of person such a product would be most appropriate for--if I think that my portfolio will easily last me until I'm 85 or so, but I'm a little worried about age 85 and beyond? Does that make me a good candidate for such a product?

Blanchett: It does. I think one problem with retirement today is that we don't usually have defined-benefit plans as much. It's all defined-contribution plans. And you don't know how long to plan for. Do you plan for retirement to last 30 years, 40 years, 45 years? It really does vary. But if you buy one of these and you say, "I am going to have this nice healthy income start at, say, age 90," you all of a sudden have an end date. You can plan up to a point, so that makes it a lot easier to say, "I can spend this much every year," knowing that if you're still alive at age 85 or 90, you're taken care of.

Benz: How about these products that are kind of a variation of the deferred annuity? They're a bit of a hybrid: If you end up needing long-term care, it can be long-term care; if you end up being healthy and living to be 105, it can see you through that as well. What do you think about those hybrid-type products?

Blanchett: These are interesting. They are complex. It's kind of this idea of a joint benefit; if you give the insurance company $100,000, you have a pool of money that you can use either for long-term care or a death benefit. It's one way to do it. I'm more a fan of plain-vanilla insurance because when you add on complexity in these different parts, it's often hard to compare policies. I think that immediate annuities are the easiest today. There are lots of providers; it's very liquid; the rates are similar. Even with deferred income annuities, you see different payouts and different rates. You see different types of products in that space, and I think it's really tough to figure out who benefits the most and why sometimes.

Benz: Speaking of complexity, let's talk about variable annuities--specifically, variable annuities with guaranteed minimum withdrawal benefits. Let's talk about why such a feature would be attractive on a variable annuity; but before we get into that, let's talk about how a variable annuity is different from the other two product types you just talked about.

Blanchett: They can be very complex, and I think that's often an impediment to purchasing them. You want to understand what you are buying before you purchase it. These are products where you have an underlying subaccount and, based upon that performance, your payout may go up or down. I think that these can be very attractive products. I think that one problem, though, is that they can often be very expensive. Oftentimes, individuals who buy them don't understand how they work and how the fees are assessed. Having seen various examples of these deferred-income-annuity products, there are both very attractive products and very expensive products. And I think that there is a much wider dispersion of good and bad in the [variable annuity] space because it is a bit easier to hide and layer fees in there. But I wouldn't just dismiss it as a product because one really important benefit of the VAs that have GLWBs, or guaranteed lifetime withdrawal benefits, is the fact that you can get your money back. You have it in this account where you can say in two years that, yes, you've paid for some insurance, but if you change your mind, you can change your mind. You can't really change your mind with the other two products types at all.

Benz: So, if I am looking at such a product or I am talking to an advisor who is telling me about such a product, how do I do my homework? Obviously, this is a huge topic, but can you offer a few quick tips about what I should be looking for?

Blanchett: I would say read the prospectus, but those things are a hundred pages. First off, you want an advisor who can explain the product simply and completely. You want to know what all the fees are. So, when thinking about the product, I usually think about three main types of fees: There are the underlying investment expenses; there are the rider expenses associated with the actual insurance portion; and there is the other stuff like mortality administration. So, you need to understand what these pieces are. One problem with these products--for better or worse--is that one may cost 2% and one may cost 3%, but they could be equivalent from a benefits perspective. What is the payout rate? How do they work? What is the step up? It's difficult to understand and compare them effectively. I think that's where you have to trust your advisor and understand what they are looking at in terms of why this is the best product for me.

Benz: David, this is such an important topic. Thank you for being here to share your insights.

Blanchett: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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