Forget plastics and hedge funds. Clients sleep better with a steady income.
Don't you hate it when a reporter discovers
something you've known all along and then acts like he invented it? I
want to avoid that trap. Last month I wrote about changing
demographics, the problem that can cause for financial advisors and the
need for more efficiently priced longevity products.
Not surprisingly, this line of thinking led to
immediate annuities. You all know about immediate annuities. But do you
use them? Most advisors I talked with over the past month do not. Why
does the word "annuity" have such a sour ring? Is it embarrassing to
recommend an annuity to a client? Well, yes, many advisors said.
Suggesting an annuity demonstrates that you don't have any better
investment ideas. Here are some specific negatives on annuities I got
from advisors:
Annuities have not changed in hundreds of years.
They cost too much. They are poorly designed and do not make full use
of ratings like insurance policies do.
Insurance companies are too conservative in calculating returns.
Annuities are an income investment but they can't compare in performance to other income investments.
We don't trust the insurance industry. "Look what happened to Executive Life," one advisor said.
Annuities offer no transparency.
An annuity is like a bond, but worse. "You can't
trade it like a bond," one advisor said. "You're stuck with it."
Capital gains are converted to ordinary income once withdrawal begins.
Annuities cheat heirs by consuming all the capital.
"People on the investment side have always hated
them because they've always deteriorated the assets in a portfolio,"
says David Diesslin, a financial advisor in Fort Worth, Texas.
O.K. But with defined pension plans disappearing and
Social Security becoming insecure, don't clients need something in
their portfolios to provide steady income? Something that guarantees
their money will never run out?
Well, a couple of advisors acknowledged, if you're a
wimp, an annuity might be an all-right product for you. That is, if you
don't have experience taking risk or managing money. So my informal
survey suggests that annuities are O.K. for people who don't have savvy financial advisors with better ideas.
Still, there are some advisors who feel strongly
that immediate annuities are a product whose time has come. "I think
immediate annuities are going to be the big story," says Harold
Evensky, an advisor in Coral Gables, Fla. "But they're not even on the
radar screen yet."
The reason for their appeal is simple, he says. Most
financial products provide a financial return in the form of dividends,
interest and capital gains. But with an annuity, there is an additional
return, which he calls "mortality return." The purpose of the annuity
is to provide a promise that you will never run out of money. For some
clients, this promise fills an important psychological need, if nothing
else. But Evensky says he uses annuities as a teaching tool as well.
Some years ago his own parents wanted to go on a
cruise but his father said they couldn't afford it. Evensky, who
managed their money, knew they could afford it but that they "were
subject to paycheck syndrome," meaning that they felt comfortable
spending only income that came in a check. Evensky took $100,000 and
bought his parents an immediate annuity. His parents felt rich and went
on the cruise. "I knew they could afford it but that they wouldn't do
it" unless they felt comfortable psychologically about their money.
Another client, this one very wealthy, lived
comfortably off the income from his muni-bond portfolio. Evensky tried
to persuade him to put more money into stocks but the client didn't
want to "gamble" with stocks and, at the same time, reduce his reliable
income from the muni bonds. So Evensky bought him an immediate annuity
and the client quickly agreed to put more money in equities. "What a
powerful behavioral tool for advisors to use to reframe the way people
think about money," he says.
Sure, an immediate annuity is a gamble, Evensky says. "You're putting
the money in and if you die early you made a bad deal, but you're dead,
and if you live you get to pick up what others left on the table."
Evenksy often uses joint annuities or an annuity with a ten-year
certain payout to relieve the client's anxiety that he will sink a
bunch of money into an immediate annuity and then die the following
week, losing his entire investment.
Unlike many other advisors, Evensky believes immediate annuities have
changed substantially in recent years. When Evensky looked into
immediate annuities a decade ago and measured the "mortality return"
for someone who lived well beyond the mortality expectation compared to
the return of a bond fund, he discovered that extra return was about
3%, not enough to notice. Ten years ago, he says "the return was just
sucked out of the annuity by the insurance company."
But that's not the case anymore. In fact, today's
products are easy to compare. Evensky goes to www.immediateannuity.com
and compares the monthly income provided by various products. He might
check to see what payout a lump sum of $100,000 would pay from various
product vendors. And of course he only uses insurance companies with
the very top ratings.
Jean Fullerton, a financial advisor at Lodestone
Financial in Manchester, N.H., makes no apologies for using immediate
annuities. She's developed a sound list of reasons why they make sense
for some clients, including one I'd never thought of: An immediate
annuity allows the client to safely take a larger withdrawal amount
during retirement versus a "safe" withdrawal rate from the same amount
of money left in investments. Recently, I talked with Bill Bengen, an
advisor in El Cajon, Calif., who has done extensive work on retirement
portfolios and "safe" withdrawal rates, given our changing
demographics. His research shows that 4.5% is "safe."
But as Fullerton says, she can transfer the risk of
outliving your money to the insurance company. That's what insurance
products are for. Fullerton says that she would consider an immediate
annuity only for a client who expects to live longer than average
"since that bias is built into the insurance product." For a client
with poor health, she says she "might consider an impaired life annuity
to give a larger payout and still provide longevity insurance."
Fullerton likes immediate annuities best for single
clients because "there is a modest longevity insurance component
inherent in marriage." And she suggests a laddered approach to buying
the annuities to spread out the risks associated with interest rates
and insurance companies. The laddered approach has the additional
benefit of increasing payouts for annuities purchased at later ages,
and keeps more assets liquid to cover future expenses or to provide for
an inheritance in the case of an early death. Evensky points out that
immediate annuities don't become viable until a client is between 70
and 80 because before that, the product offers very little mortality
return.
Even Glenn Daily, a fee-only insurance consultant in
New York who rarely has good words to say about insurance products,
likes the immediate annuity. "I'm not aware of any insurance product
that has received as much praise from economists as immediate
annuities," Daily says. When economists do their "money's worth"
calculations, they find that you get back 90% or more of what you put
in to an annuity in terms of the economic value of the payments as a
percentage of the cost. "Economists have been puzzled by the low demand
for immediate annuities," Daily says. "If immediate annuities were a
bad deal, there would be no need to write papers for economics journals
trying to explain the puzzle of why advisors don't use them." Daily
suggests that few advisors have done an objective economic analysis of
immediate annuities.
Now that Evensky's sold himself on immediate
annuities, he might even be ready to touch the untouchable: the
deferred annuity. "If I expect someone to take a chunk of money at 75,
it makes a lot of sense to save the money tax-deferred and then take it
out tax-efficiently," he says. "Thinking about deferred annuities
begins to make more sense." Evensky likes no-load annuities from
companies like Vanguard, TIAA-CREF, Fidelity and Charles Schwab. Will
the sellers of annuities be ready for the landslide when all the
financial advisors begin following Evensky and Fullerton to annuities?
Who knows? Then again, maybe it won't happen.
Mary Rowland has been a
business and personal finance journalist for 30 years, a half dozen of
them as a weekly columnist for the Sunday New York Times.