Making Annuities More Attractive

Unloved Ask Morningstar's retirement-methodology team about annuities, and they will offer fulsome praise. When they model investment strategies for retirees, they invariably end up recommending big dollops of annuities for those that need lifetime income. The reason, as Morningstar's Paul Kaplan states, is that "self-created longevity insurance is very expensive." Retirees who want guaranteed income—and most do—are best served through a pooled holding, rather than achieving that guarantee on their own.

That theoretical attractiveness hasn't translated to the marketplace. Last year, reports the trade publication Ignites (no link; paywalled), annuities recorded $204 billion of new sales. In contrast, several trillion dollars flowed into mutual funds and exchange-traded funds. (Net sales were $700 billion, but gross sales—which is how annuity purchases are measured—were several times higher.) If the investment market were a meal, annuities would be a shrimp cocktail.

First Impressions Their first problem is their label. Nationwide informs me that there are four types of annuities: 1) variable, 2) immediate, 3) fixed, and 4) fixed index. Say what? The average American would be likelier to spell "eudaemonic" correctly than to define each of those four terms. (Perhaps the average investment columnist as well; I did not know what a fixed-index annuity was before reading Nationwide's piece.) What's more, not only do these four investments confuse potential buyers by sharing the same name, but it's a non-intuitive name at that. A bond makes sense. Ditto a fund. An annuity … sounds like an actuary's task.

My suggestion: Switch from “annuity” to “guaranteed income.” The latter label contains two common words, rather than a single uncommon one. In addition, it lists the two reasons that a retiree would have to buy an annuity. The first is for the guarantee. As stated above, these are insurance payments. The second, of course, is for the income. People might not know that they seek an annuity, but they certainly will recognize that they desire guaranteed income. Give the public what it wants.

Rebranding annuities as guaranteed-income vehicles makes them sound more appealing, but does not address the confusion that arises from having multiple varieties of the investment. (In addition to Nationwide’s four groupings, there are additional options, such as the possibility of receiving inflation-adjusted disbursements, or selecting various time periods over which to defer the payments.) I don’t have an answer for that difficulty, but the right marketing experts should be able to come up with something.

Name that Price! The next and even-larger concern is cost. A mutual fund or ETF investor knows exactly how much the management company charges; that information is freely available, as the company is required to calculate and publish its expense ratio. The annuity buyer, on the other hand, operates in a fog. Most annuities do not carry expense ratios.* Naturally, they have costs, which reduce the amount of income that is available to the investor, but the amount of those charges cannot be determined by an outsider.

*The exception being variable annuities, which behave like mutual funds by investing in a specified pool of securities, and thus carry an expense ratio that is similar in structure to that of a mutual fund—although generally much higher.

Justifiably, that uncertainty detracts from the annuity's appeal. What the investor does not know might indeed hurt her. In fact, it probably will. As a general rule, when financial products are permitted to bury their costs, rather than state them explicitly, they do not come for cheap. When the SEC warned investors a few years back about the risks of structured notes—another financial offering that doesn't have expense ratios—it also cautioned such notes tended to be "expensive."

Annuities could change that, if they wished, by calculating and publishing their expense ratios. The process would be trickier than doing so for a fund, because the assets used to pay an annuity wouldn’t necessarily be segregated, but the task could be accomplished by allocation. The annuity provider, after all, would know precisely its total costs, and precisely its total financial obligations. Thus, at the least, it could publish an average expense ratio for its entire book of business.

In 2018, transparency is very much a marketing virtue.

Forty-Nine Too Many As insurance offerings, annuities are subject to various state regulations—which, unfortunately, may differ from one to the next. For example, should an insurance company fail, its annuity owners won't necessarily be left high and dry. As with bank CD owners, the safety of their purchases is guaranteed by a government body, up to a certain level. However, whereas the Federal Deposit Insurance Corporation protects all CD holders by the same amount ($250,000 per bank), the annuity guarantee varies by state.

Having 50 sets of government rules for annuity purchasers is 49 sets too many. There may well be a role for state-insurance departments, with enforcement or in crafting regulations for situations that are unique to that state, but setting individual policies where one policy will do is not one of those roles. The annuity business would benefit from having a single, national set of standards.

Up and Coming This column addressed annuities' perception problem. Friday's installment will cover some of the investment issues. What are the best uses for annuities, according to the methodology team's models? What are the major concerns? How might annuity providers improve their offerings, so that they become better investments?

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.