Many planners hate them, but they may be attractive for clients with longer lives.
For the last two decades, advisors tend to continue seeing the debate
over annuities as a Manichean battle between light and dark, with
people rallying around the two sides of the argument as if they were
marching under the standards of the crescent and the cross.
The debate is familiar: Annuities traditionally were seen by some,
specifically by many fee-only financial planners, as a much-too-dear
way to buy peace of mind from an insurance company, which is catering
to people's emotions about ruination more than to their logic. After
all, the products have high internal expenses and usually come with
heavy sales charges. And some brokers sell them improperly for their
tax advantages, even to people doing IRA rollovers who don't need to
pay extra for the privilege.
As interest rates have declined in a secular fashion since the 1980s,
the challenge of generating sufficient retirement income has spawned a
re-examination of these vehicles. Annuity defenders say that having a
fixed amount of income, perhaps one guaranteed for life, in age when
lives are getting longer, is often worth the expense, particularly for
retirees whose savings can be subject to the whims of uncertain
markets. Just ask folks who retired at the end of 1999 to find out that
the financial house they had put in order was a sand castle.
This play is complicated by the roguish behavior of some salespeople,
however, who feast upon commissions by putting a person's entire nest
egg under the lock and key of the insurer's coffers and leave the
customer in a financial straight jacket-sometimes without even enough
money to live on, unless they want to pay steep fees to wrest their
money back.
"Insurance companies are like Las Vegas. They always win," says Rick
Fingerman, a planner in Newton, Mass. "You see they've got the biggest
buildings in every city, so they must be doing something right." But he
also adds, "It's not the product that's the issue, it's the people
selling them."
These debates ignore the real-life modus vivendi, which is that
planners often use annuities and clients often like them, at least when
they are used correctly. Some clients even say outright that it's worth
it to them to pay a little extra, because frankly the idea of running
out of money is worse. When the chance of outliving the money is
greater, or when medical problems might arise, the guaranteed stream of
income of an annuity provides the kind of infusion needed, where stocks
and mutual funds face a short-term risk and bonds may not bleed enough
money.
The insurance companies, in the meantime, have stepped up with better
products, competing with each other with more aggressive contracts and
stronger guarantees, all to the good of the consumer.
"I'm not a big insurance guy, but the facts are the facts," says
William Garrett, president of Garrett Financial LLC in Brentwood, Tenn.
Garrett says he started his professional life in the insurance business
20 years ago, but quickly exited it after a year and a half in disgust.
For a long time, he wouldn't go near any of their wares. Now he's
thinking again.
"I've grown up, and the products have grown up," he says. "Even if I
have to back up and eat crow and go to a wholesaler, there are better
[annuity] products out there-much better than there were 20 years ago.
We've run the numbers and done the research, and in an awful lot of
cases, when you factor in all the costs on both sides of the equation,
if you're talking tax-deferred versus a taxable account, the annuities
come out cheaper."
To Garrett, annuities have become attractive, not as a piggy-bank for
all of a client's assets, but as an easy way for clients to shake the
money tree in such a way that the growth part of the portfolio is left
alone to sprout. "That's why I'm infatuated with it," he says. "I was
doing it with bond ladders before. But this is much easier, much
cleaner, and has a lot more features going for it."
Stepping Up With My Baby
People quibble over different types of products. Garrett likes the
guarantees that come with variable annuities, but Gala Gorman, a wealth
manager with Five Points Financial in Franklin, Tenn., says she still
doesn't believe variable annuities are still justified by their
expenses. She prefers fixed annuities, using them, for example, as a
way to use money from a reverse mortgage if a client needs extra income.
Keith Singer, a planner in Plantation, Fla., with Keith Singer Wealth
Management, likes immediate annuities, especially for those clients
with health problems. "If you have medical issues, you can convince
insurance companies to pay you more money," Singer says. "I had a
75-year-old man just get $32,000 a year for a $200,000 annuity.
Although he's getting 16% a year, when he dies that money is gone, so
he doesn't have enough for his wife. So he bought life insurance also
and now he'll net $22,000 a year for the rest of his life, and his wife
will get $200,000 when he dies. So they're getting 10% to 11% a year
and then the $200,000."
In contrast, if you tried to take 10% to 11% out of an equity portfolio
that way, he says, chances are good that the money would be totally
sluiced out before the client died.
The idea of buying a single-life annuity that pays more and buying
insurance with the difference, a strategy known as pension max, can be
tricky, but many planners say it's doable if it's structured correctly.
"Before you make the decision, you must make sure you can qualify for
the life insurance," says Ken Shapiro, a CPA and CFP in Hazlet, N.J.,
with Shapiro Financial Security Group Inc. "Because of health issues,
either the people weren't qualified for insurance or the premiums were
too expensive. ... Some people make the decisions on one part and did the
single life, but when they went to apply for the life insurance they
couldn't do it."
Singer says that the key to this strategy is finding two different
insurance companies who are looking in different ways at the same
client and his medical health. "That's where there's the arbitrage," he
says. "That's why you're getting two different companies to think
differently about you."
The Tontine Pool
Tom Davison, a partner with Summit Financial Strategies Inc. in
Columbus, Ohio, was given the task of defending single-premium life
annuities at the Chicago NAPFA conference in the first week of May.
Sitting alongside William Bengen, president of Bengen Financial
Services Inc. in El Cajon, Calif., he gave a presentation trying to
persuade a potentially hostile group of fee-only planners that there
were advantages of using this type of annuity over laddered bonds.
He showed a comparison between the two, looking at $100,000 in a
single-premium immediate annuity paying out 8.47% from age 65, and the
same amount in a 5% laddered bond portfolio. The internal rate of
return in the annuity, which takes out $8,472 a year, runs mainly
backward until sometime between years 11 and 12, when the payouts catch
up with the principal and the car starts to move in forward. After
that, the return on the investment begins rising until some time after
the client turns 82, when the return in the annuity starts to rise
against that of the laddered bonds and keeps rising. Not that it
matters, because at about the same time, the money in the laddered
bonds has been exhausted.
What justifies the expenses is the "mortality credit," a concept
Davison attributes to Moshe Milevsky (author and associate professor of
finance at York University in Toronto), one that says that an aging
client can eventually make a better return off an annuity because he's
getting, in effect, a credit for living. Davison asked the NAPFA
attendees to imagine a tontine pool.
"Five 95-year-old females get together. ... And they each put $100 into
the pool and the agreement is that only those living at age 96 will
share the money. The survival rate is 80% for 95-year-old females. They
invest it at 5% interest a year. And then step forward a year and now
it's $525 with interest, but there are only four women left. So the
four ladies divide up the money and each gets $131. That's a 31% return
on investment. That's 26% more than the investment rate of return, what
Milevsky calls the mortality credit."
This type of pool is popular in mystery novels, ones like Agatha
Christie's "4:50 From Paddington," probably for the same reason they
have widely been banned-because they provide an incentive to murder
your co-investors. However, Davison uses it to illustrate that it's not
just the rate of return on an investment that matters, but the economic
consideration of longevity insurance, which many planners aren't taking
into account when they shun annuity products.
It's a principle that comes into effect, he says, "Particularly when
you buy [annuities] later on. That's why buying them later might make
the most sense. Particularly at age 80 and on. Then you're getting a
bigger kicker for this mortality credit. You're one of the long-lived
ones, and everybody else who dies contributes to your good fortune."
Using An Annuity To Hedge Bets
Shapiro says that he also was hostile to annuities for many years, and
it was only in the last few years that he began looking at them again
because of the features offered in the new generation of products. One
of his clients, he remembers, wanted to retire early and get at least a
7% to 7.5% return on his money over ten years.
Shapiro couldn't promise what the market was going to do, but he could
put at least part of it in an annuity with a 7% guaranteed return net
of fees, which he would then have to annuitize. "If the market fell
apart, at least he would get that [part] guaranteed," Shapiro says.
By annuitizing only part of the kitty, Shapiro had a foundation to make
the client more aggressive in other parts of the portfolio. And this
might be another way to look at an annuity: as a sort of hedging tool,
a way to buy insurance on certain parts of any portfolio.
"A colleague of mine told me that because of that living benefit-the 7%
guarantee-what he was doing was putting the most aggressive investments
into the annuity," Shapiro says. "So if you wanted, lets say, a
small-cap growth component, he was going to do that inside of the
variable annuity,