At the end of the third quarter, the Secure Retirement Institute (SRI) calculated that total annuity sales fell 8% from the corresponding quarter a year ago. Todd Giesing, senior annuity research director at the Windsor, Conn.-based SRI, attributed the drop, in part, to low interest rates. “Interest rates impact all individual annuity products’ pricing,” he said, adding, “Low interest rates are likely to lower the amount of guaranteed income created by an annuity.”
Low interest rates are often used as a reason for avoiding annuities, but does it make sense to wait for higher interest rates before buying one of these products?
Hard To Predict
It’s impossible to predict when interest rates will change.
“Annuity payouts are definitely tied to interest rates,” says David Blanchett, senior education fellow with the Alliance for Lifetime Income and head of retirement research at Chicago-based Morningstar Investment Management. “So if interest rates rise, payouts are going to increase. The problem is we don’t know when, or if, this is going to happen.”
It’s like trying to time the market: impossible. “It is very difficult to predict when [interest rates] might rise,” says Eric Henderson, president of Nationwide Annuity in Columbus, Ohio. “If an annuity is the right solution for a client at the current time, it is probably unwise to gamble on rates going up.”
Yet there’s another, even more compelling reason that waiting to buy an annuity may be misguided.
Mortality Pooling
It has to do with the way annuity payouts are calculated. Generally, the payout amounts are based on not just interest rates but also on “mortality credits” or “mortality pooling.” Those are actuarial terms that basically relate to your life expectancy at the time you buy an annuity. Older annuitants, who are more likely to die sooner, help fund the payouts to younger annuitants.
Or, to put it another way, the older clients are when they buy an annuity—i.e., the longer they wait—the lower their payout rate will likely be. “Waiting is going to ‘cost’ you,” says Blanchett.
It’s also a matter of relative value. When interest rates are low, bonds—the other traditional sources of retirement income—aren’t very appealing. One can argue it makes more sense to buy an annuity now simply because it’s so hard to get a reasonable income level any other way.
Relative Value
“The relative value of an annuity actually rises the lower interest rates go,” Blanchett explains. “Interest rates are going to affect all investments, but you only get mortality pooling when you annuitize. [You don’t get it from buying bonds or any other instruments.] Lower interest rates have reduced both the returns on bonds and the expected payouts on annuities, but the mortality pooling aspect hasn’t really changed at all. That means you’re going to be able to generate more income from an annuity today, relatively speaking, than from a bond portfolio.”
Tim Seifert, senior vice president and head of annuity sales at Radnor, Pa.-based Lincoln Financial Group, a big annuity provider, gives an example: Lincoln’s income rate for a 65-year-old annuity holder today is 4.75%, and the current yield on a 10-year Treasury bond is only about 0.75%. That’s a difference—a spread—of 400 basis points. A year and a half ago, however, the same annuity was paying 5.75% while the Treasury was paying 3.25%, a difference of just 250 basis points. “The value proposition of the annuity … has arguably never been better,” he says.
Of course, the decision of whether it’s a good time to buy an annuity depends on many factors—key among them: the client’s goals, risk tolerance and individual financial situation. “The good news is that, despite low interest rates, consumers have many types of annuities to choose from,” says Andrew Melnyk, chief economist and vice president of research at the American Council of Life Insurers in Washington, D.C.
For those looking for income guarantees to help with fixed costs, for instance, a fixed annuity “may be an attractive option even at today’s current interest rate level,” says Corey Walther, president of Allianz Life Financial Services in Minneapolis. “[But] if they are more focused on building their assets and can tolerate a higher level of risk, a fixed annuity probably isn’t the best choice.”
Even in that case, though, annuities shouldn’t be ruled out altogether. “There is never a bad time to consider whether or not an annuity can be a beneficial addition to your portfolio,” says Walther.
Equity Exposure
Indexed annuities, which peg performance to a market index such as the S&P 500, might capture more market upside in a low interest rate environment because they are “structured with greater exposure to the equity market,” says Dianne Bogoian, vice president and head of product development for Prudential Annuities at Newark, N.J.-based Prudential Financial. “They also absorb some downside risk while potentially helping investors grow their assets.” (Indexed annuities offer a portion of the index’s upward movements and a cushion against downward movements.)
Another option is to choose a rising income payout that’s deferred for several years. “Investors can choose variable or fixed indexed annuities with lifetime income benefits, where income payments can potentially increase over time with stock market gains,” says Frank O’Connor, vice president of research and outreach for the Insured Retirement Institute in Washington, D.C.
Yet another type of annuity that’s been growing in popularity is the structured or buffered variable annuity, sometimes called a registered index-linked annuity. This also links returns to a market index, but its caps and floors work differently. Because registered index-linked annuity holders benefit from market growth, with downside protection, these annuities are better understood as equity-like holdings, not bond substitutes.
Pete Golden, chief sales and distribution officer of individual retirement at Equitable, the New York-based annuity provider, calls the registered index-linked annuity a “less risky way to access some potential upside with downside protection.”
Annuity Opponents
Still, some advisors oppose annuities regardless of interest rates. “A prudent investor would probably conclude not to buy an annuity in the first place,” contends Ric Edelman, co-founder of Edelman Financial Engines, an independent advisory firm with more than 150 offices nationwide and more than $200 billion in customer assets.
Among his complaints is that annuities tend to be expensive and tie up clients’ money. Nevertheless, he adds that a no-commission, low-fee variable annuity is “less impacted by interest rates due to the subaccount diversification opportunities,” referring to the mutual-fund-like subaccounts where client assets are invested.
On the other hand, annuity advocates insist there are always strong reasons to consider them. “Annuities can be a really valuable strategy for providing income, accumulation and protection as part of a portfolio,” says Woodland Hills, Calif.-based Todd Solash, chief executive officer of individual retirement at insurance giant AIG. “Their relative value today is very strong, and from an income perspective there really are not alternatives that provide guaranteed lifetime income.”