Fixing A Retirement Course

Indexed annuity sales are setting the market-pace, revealing some new consumer buying habits

by Andrew Murdoch

A funny thing is happening in the annuity sales world that merits attention, in part because it serves as a reminder of a long-standing issue about buyer education.

As almost everyone in the annuity business knows, annuities are mostly sold, not bought. There is nothing wrong with this, but it underscores the need for some brokers to take buyer education more seriously and make sure clients fully understand what they are buying and why — as well as why the annuity they select is better for them than alternative annuities.

This is particularly important given the Department of Labor’s recent passage of new regulations requiring financial planners to take fiduciary responsibility for their clients.

Soaring Indexed Sales

The “funny thing” I refer to is the fact that sales of fixed indexed annuities (FIAs) continue to soar while sales of most other annuities are flat or down.

FIAs, of course, are fixed annuities with a variable rate of return, depending on the performance of the underlying market index. Their sales posted a six-year high in 2015, according to the Insured Retirement Institute. In 4Q 2015 alone, FIAs posted record sales of $16.1 billion, more than a 32 percent increase from sales of $12.2 billion in the fourth quarter of 2014.

The contrast with total annuity sales is noteworthy – they totaled $228.8 billion in 2015, nearly unchanged from $229.4 billion in 2014.

What gives with FIAs?

Some of their buyers know exactly what they are getting and are happy with their purchase. Others, however, do not understand what they truly get – and do not get – when they buy a FIA. Many FIA buyers think they are getting market-like returns with no risk because FIAs, unlike variable annuities (VAs), don’t decline in value when the market drops. What they often don’t appreciate, however, is that they get sharply reduced market returns – typically a maximum of half the stock market’s performance.

At least some FIA buyers are opting to buy FIAs over variable annuities (VAs), whose returns fully reflect market performance, because of concerns about near-term stock market prospects. This makes some sense — but less when you consider that most VA buyers purchase a living benefit rider guaranteeing annual lifetime income, a guarantee that makes it a lot easier to withstand market sell-offs.

As I said at the beginning, the real point of all this is that all annuity buyers would be better off independently examining what they are considering – preferably at the request of their brokers – and carefully choose among different annuities. This is the only way for someone to buy an annuity that truly fits their particular needs.

To this end, here is a mini-primer on the five major types of annuities and what type of investor each may make the most sense for:

Fixed Indexed Annuities (FIAs)

The biggest attraction of FIAs is that you can invest in the stock market with impunity because you can’t lose money. It’s also true, however, that FIA owners earn materially less because they receive only a portion of returns are tied to an index, such as the S&P 500. Brokers don’t always tell clients this because a FIA, unlike a VA, isn’t a regulated security. Twice as many brokers are licensed to sell FIAs as VAs.

This caveat notwithstanding, many prospective annuity buyers are still a good fit for FIAs. FIAs are the right product at the right time for many pre-retirees and retirees – as long as they know what they-re buying – because they provide some equity exposure with no downside risk. They also offer income protection through riders with relatively generous lifetime income payments. FIAs make the most sense for people who still haven’t forgotten the enormous market selloff in 2008 and want to approach the market gingerly.

Variable Annuities (VAs)

VAs, still the best-selling annuities despite declining sales, make the most sense for pre-retirees and retirees who want long-term exposure to the stock market, which for most people is the only way to really win. But VAs aren’t for the faint of heart, and not just because VA owners can lose money. In today’s volatile stock market, VA sales fluctuate like a yo-yo, sparking concerns about whether this is really a secure retirement investment.

Nonetheless, VAs make sense for those with the proper mindset. They offer full market exposure with tax deferral and guaranteed living benefits, which offset most of the pain of a falling market. VAs are offered with a group of investment sub-accounts and, like FIAs, offers a standard death benefit. VAs do charge the highest annuity fees.

Fixed Annuities

If you want an annuity that is straightforward and simple – i.e., unencumbered by the likes of fees or riders – a fixed annuity is probably your cup of tea. It pays more than a bank CD, likewise offers a guaranteed interest rate and provides absolute certainty about exactly what you will get and for how long.

The most popular type of fixed annuity is a Multi-Year Guaranteed Annuity (MYGA). MYGAs pay a guaranteed rate of interest, generally 2 percent to 3.3 percent for three to 10 years, and many allow buyers to withdraw 10 percent of their account value annually without penalty.

Immediate Annuities

Immediate annuities make the most sense for those who want to get the highest interest rates possible in an uncanny era of super-low interest rates that show no sign of rising significantly, notwithstanding Federal Reserve action.

These pay more than other annuities. Annual withdrawal rates in a typical non-immediate annuity average 4 to 5 percent. By comparison, the annual payout of an immediate annuity can be as high as 10 percent, depending on the buyer’s age (the older the buyer, the higher the payout rate). And because the payout rate is derived from the tax-free principal invested in an immediate annuity, as well as interest, the tax rate on payments is lower.

The drawback of immediate annuities is that buyers sacrifice principal in exchange for higher payouts. Immediate annuities also have skeptics because of so-called life-only immediate annuities, which pay the highest income stream but offer no death benefits. Many people falsely think all immediate annuities work this way.

Deferred Income Annuities (DIAs) – Say you want an annuity that offers the most for your money at a point in the future, knowing you have no need to turn on an income stream anytime soon. If so, a DIA is probably right for you. A DIA is a high-paying immediate annuity that delays payments until you elect to receive those years down the road. It makes the most sense for somebody who is 50 to 65 years old, still working and doesn’t plan to retire for years.

By delaying payments, buyers give themselves a pension in the future – and one fatter than other annuities because the insurance company isn’t on the hook to make payments as long. DIA withdrawals are also taxed at a lower rate.

More so than other annuities, DIAs protect people from outliving their savings — and for less money. The drawback is uncertainty about how long you will live. Potential buyers should be healthy and have a family history of longevity. The other DIA drawback, of course, is that, unlike other annuities, buyers don’t have the option of withdrawing 10 percent of their interest a year, penalty-free.

That’s because a DIA is a type of immediate annuity. Hence, the principal is gone. ◊