FIA: Dream Investment or Potential Nightmare?

Rebutting Jane Bryant Quinn

Recently, Jane Bryant Quinn wrote a column for the AARP Magazine and website trashing fixed index annuities. While many of the points Ms. Quinn states are in fact accurate, that doesn’t make them true. Accuracy and truth are not automatically one and the same. In fact, accuracy can be used to twist the truth and support complete falsehoods. We’ve seen it thousands of times in our politics. People on both sides of the aisle taking comments from the opposition out of context, packaging them convincingly in a provocative manner and often juxtaposed with an unrelated image, accurate but false. Factoids without truth, spreading lies and causing significant damage. Extremely effective because of an intellectually lazy and gullible electorate which by and large merely wants its prejudices and biases confirmed.

Not only do they reflect an egregious ignorance of the subject, a clear bias that prohibits any kind of clear thought, but they also do an awful lot of harm to people who could otherwise benefit from a great opportunity. Especially when someone of Ms. Quinn’s stature and who should know better promulgates the falsehoods. Further, it takes only a few hundred words to completely trash something, but often a lot more to rebut and correct the record.

Where Ms. Quinn went wrong was discussing FIAs as a product, and not a component in a financial plan. Several of her problems actually disappear when they become part of a well-thought-out plan.

She starts her column, thus:

“You buy the annuity with a lump sum, which goes into the insurer’s general fund.”

So far so good. Accurate, factual and true. However, she goes on outlining the following as problems:

Low returns.

“Salespeople might claim that FIAs could earn 6 or 7 percent a year. But with fees, they’ll struggle to match the low returns from bonds, says Michael Kitces of the wealth management firm Pinnacle Advisory Group in Columbia, Md.”

Returns are relative and do not happen in a vacuum. In addition, returns are always accompanied by risk. It is therefore important to understand FIAs are not securities. When compared to the market, 3-4% does indeed sound low. However, these are safe-money insurance products. JBQ said it herself, “You buy the annuity with a lump sum, which goes into the insurer’s general fund.” The same general fund that every dime of fixed annuities, whole life, universal life, etc., goes into. These general funds are managed for safety, growth, and stability, and along with actuarial components are the core engine that drives the massively huge, stable, and profitable life insurance industry.

Life insurance companies are very profitable. Typically, they make about two percent a year on the total value of their general fund holdings. So, if you have $50 billion in assets in your general fund, your annual revenue stream is going to be about $1 billion. Using other people’s money and without incurring any risk for you or your policyholders. In this low-interest rate environment, the general fund yields, say 5%, they deduct the first two and that leaves three to pay the policyholders. So, 3% in a very safe, treasury or CD equivalent. That sounds pretty like pretty high returns to me. Where else can you purchase a CD or treasury and make 3%? You can’t. The reason is the insurance company has so much investable cash. In essence, they become what’s known as “market makers.” Essentially that means there are opportunities available to them that are not available to you and me. The up-front 2% is simply the cost of participation.

Under this scenario, as the client, you have the option of getting a 3% payout or participating in an index annuity where the insurance company uses the interest to buy options in an index like the S&P 500. If the index goes up, you get a portion (not all…it’s only the interest that’s participating, remember?) of the gain. If not, the options expire and you get to do it all over again the next year. You haven’t gained anything, but you haven’t lost anything either. Just the interest you might have earned in a more traditional fixed product. To reiterate; your money is NOT in the stock market. You take no risk with the principal. Therefore, how could you expect to get the same rates of return as equities and bonds, which do put your holdings at significant risk?

High fees. 

“You can’t find out what you’re paying for investment management. Costs are buried in the black-box system used to adjust the credits to your account. Sales commissions run 5 to 7 percent and may be hidden, too. Under the new fiduciary rule, which requires advisers to put your interests ahead of theirs, commissions have to be disclosed if you’re buying the annuity for a retirement account, but not for other accounts. Salespeople sometimes claim, falsely, that their services are free.”

A key way to distinguish between commissions and fees is commissions are typically paid by the seller, whereas fees are paid by the buyer or recipient of the service. Annuity agents are paid a commission by an insurance company. That commission is built into the pricing of the product and comes out of the 2% the insurance company takes off the top. If you stay in the contract, you won’t pay the commission. If you should get out early, you will have surrender charges that will cover those costs. And yes, they can amount to as much as 5%-7%, for the duration of the contract. If you are doing an income plan, that can last several decades.

Mutual funds, 401ks, REITs, variable annuities, and their like carry fees, high fees. These fees are deducted from your accounts every year. Fees that reduce your return significantly (up to 80% if you believe Jack Bogle, the founder of Vanguard) but don’t buy you anything.  Compare the two. Annuities have commissions that run 5% to 7%, and which don’t come out of your pocket as long as you abide by the contract terms. That means if your account averaged 5% since the year 2000, $100,000 would have grown to $229,202 as shown in example (B) below.

 

But remember, the fees you pay on mutual funds and the like come out of your pocket every year. Year after year after year. And not just on the initial deposit like with an annuity. No, those fees are based on the full value. So, if you lose money, you will pay fees, but if you make money, you will pay even more. Over a 10-year period, a mutual fund could cost as much as 20% or even 30% of the initial deposit, as opposed to the 5% to 7% paid on an annuity. In the above example, the S&P 500 would have only grown to $175,507 (A), without fees, and $124,491 (C) with average fees of 2%. That’s a difference of 29% over the 17-year period depicted. Note how the impact of fees is not just confined to the cost of the fees, the opportunity cost of the missing assets is also deducted. Then, when you take income from it, the account is depleted completely by 2015 (E). Alternatively, the 4% compounded return only shrinks to $94,976 (D) after income, demonstrating how superior it is when discussing income solutions.

Profit limits.

“Every year, the insurer can raise or lower the amount of future gain credited to your account. You face a high risk that returns will be adjusted down.”

Again, accurate, but misleading. Yes, caps, participation rates, spreads, and all the other rate “modifiers” can be adjusted up or down. But it is determined by market and economic forces, such as the cost of options and interest rates. Remember, the insurance company already got its money. At the front end, right off the top. What typically causes caps and the like to fluctuate are the cost of options, and the amount of money the insurance company has to spend on them, i.e. interest rates. Digging a little deeper, we find these products have a great benefit over bonds and other securities. Rising interest rates help the policyholder rather than diminishing the value of the holding as in equities and bonds, where rising interest rates typically reduce the value of the holding. In addition, rather than obscuring the transparency of the annuity, having it tied to an index increases it, as you have an independent, publicly disclosed, and printed, index to refer to when trying to determine your net asset value.

Poor liquidity.

“You can usually withdraw 10 percent in cash, each year, without breaking your guarantee. But you’ll owe surrender charges if you need your money back before five or 10 years are up. You might also forfeit some gains.”

I would rephrase that and call it “limited liquidity,” but who cares? This statement simply reveals a lack of understanding about the planning process, or anything else to do with finance. It’s misleading on many levels. First, liquidity is relative. For example, how liquid is your market-based assets when the market is down? Refer to (F) on the chart above. What would be the cost of liquidating your holdings then? About 40%. I know, for example, the annuity will have a surrender charge that will begin at between 10%-12% and be reduced over time until it is ultimately phased out entirely. Can you say the same about the market? Isn’t it possible to hold market assets for years, then experience a sharp decline, that if you were to sell would reduce the value of your holdings significantly? No matter the contract, nothing eclipses a 40% surrender, which is exactly what the market-based assets would be reduced to should you elect to withdraw them at that point in time.

How predictable is that? Do you ever know what your market holdings will be worth tomorrow? That sounds like a mystery surrender charge to me.

With market assets, you don’t have any idea of the actual value of your holdings until you sell them. They could go down dramatically at any time. With fixed annuities, indexed or otherwise, the interest you earn each year is credited to the contract and becomes part of your principal, thereby softening the surrender charges year over year until they are phased out completely.

With an index annuity, you know exactly what the surrender charge will be at any given time. You can plan for it. In addition, if the planning is done correctly, you would understand at the outset that you don’t want to put all your money in an illiquid product. So, you might put 10% in liquidity, 50% in the market, and 40% in an annuity. If you need money, you would start with the liquid assets, then review the market-based assets to see if that’s viable. Correctly planned, you would never face the prospect of surrendering the annuity early.

There is, in fact, a very real benefit derived from surrender periods and charges: fund stability. The insurance company knows how much money it will have to work with and for how long. That makes it feasible to go long on debt, for example. Since the insurance company knows it will have your money for an extended period, it can maximize returns without increasing risk. That’s a good thing.

Lifetime benefits.

“For about 1.5 percent a year, you can add a “guaranteed lifetime withdrawal benefit” to your FIA. Promised yearly payments run about 5 percent. But, Kitces asks, why do it? Your basic FIA already provides a lifetime income. What’s more, 5 percent is not a return on your investment. The insurer is merely paying you your own money back, in 5 percent increments — and charging you 1.5 percent for the “service.” If you live long enough, you’ll exhaust your money and the insurer will pay, but that doesn’t happen often.”

“For a guaranteed income, try a plain-vanilla immediate or deferred annuity. It’s cheaper, and you’re not apt to be led astray.

First, most index annuity income rider fees are about 1%, some even less than that. I am not aware of any that run 1.5%, though that doesn’t mean they don’t exist. I just don’t sell them. Second, there is a good reason for both the riders and the fees, which provides a real advantage over the plain-vanilla immediate or deferred annuities JBQ would like you to purchase. And this goes to the most powerful advantage of the index annuity, lifetime income.

The most serious problem people have with retirement planning is knowing how long to plan for. If you are 60, and planning to retire at 70, how long do you have to make your money last? At 65, there is a 50% chance you will live to around 80, and a 25% chance you will live into your 90s. If you are married, you can up that to around 80% and 40% respectively. The prudent person would plan for 25 years or more.

A market-based planner will want you to limit your payouts to around 4%. Otherwise, you will be at significant risk of running out of money. If you have $500,000 saved, you would be able to get about $20,000 in starting income. However, if you believe Morningstar and T. Rowe Price, you should probably reduce that to 3%, meaning $15,000 a year. I think it’s important to note that you could make your money last for 25 years just by putting it under your mattress and spending only $20,000 a year. Seems like the market hurts more than it helps. You can see why in the chart above. The heavy losses at point F, early in the game, create a deficit that can never be recovered from. It’s also important to note, in light of her statement, “What’s more, 5 percent is not a return on your investment. The insurer is merely paying you your own money back, in 5 percent increments — and charging you 1.5 percent for the ‘service,’” that market-based income calculations are also based on a return of your money, not a return on it, and will charge far more than 1% for the “service.”

Insurance companies do the distribution calculation differently and therein lies their power for income planning. The actuaries know the answers before you even start planning. For example, if someone who is retiring at 70 has a life expectancy of 80, they can pay out much closer to 10% than the 3-4% derived from the market. They can do this because they take all the money deposited by all the policyholders and pool it. Life expectancy, after all, only means half the people in the pool have died, and half are still alive. If the average life expectancy of the pool is ten years, the insurance company can leverage the individual longevity risk of each person and pay all the money out as if everyone was going to live for 10 years. The reason is, everybody doesn’t live 10 years. That’s the average. So you pay everyone the average, and the people who die sooner will pay the their leftover premiums to those who live longer.

The downside is you lose your money. We call this “committing annuicide,” because it involves giving up control of your money to purchase the annuity. In the above example, the cost of the program is $500,000. If you put up the $500,000 and only collect $50,000 for five years, your effective fee will have been $250,000, or the amount you did not spend, and could not pass on to your beneficiaries. The index annuity addresses this by charging that pesky 1% fee JBQ hates so much, and that provides the money necessary to pay for those extended lifetimes. if you die after five years, the insurance company returns whatever is left in the kitty less those fees, meaning it only cost $50,000 to ensure lifetime income rather than the $250,000 the “plain vanilla” annuity cost.

One final point. With the traditional immediate annuity, you are not going to get anywhere near the 10% annual payout. The reason is these annuities start paying immediately. The reason you can get the 10% payout with the deferred annuity (straight fixed or fixed index), is because you can invest it earlier and the insurance company gives you credit for that. So, if you know you have $500,000 for retirement, and the amount believe you will need is $25,000 a year above Social Security, put $250,000 in the FIA when you are 60, and after 10 years your income payments will have doubled to 10%. At that point, you will have $25,000 a year for as long as you live, and be able to do whatever else you want to do with the other $250,000, knowing you will have enough income to live out your life in security. Guaranteed.

JBQ’s problem with FIAs has nothing to do with the FIAs. It has to do with her approach. She wants to treat them like a product, rather than a solution to a problem, and she wants to do her analysis in 800 words. Good for her; bad for you. My recommendation is to find an actual income planner, not like the money manager she interviewed for her article. The money manager wants to keep your money in the market, since that’s where he makes his money. The income planner, while wanting to make money as we all do, will understand the products best suited for lifetime income, and you won’t be led astray.

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