Annuity Buyers Seek Safety, Risk Guarantees

Many complex product features require careful review to make the right decision.

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Annuities may include a dizzying array of insurer promises and product features. We'll cover some of them but if you're seriously interested in an annuity, you probably should seek out a financial adviser with experience in annuities. Much of the information here was obtained via reports and interviews from experts at the Insured Retirement Institute (IRI) and another trade-supported organization called LIMRA.

[ Before proceeding, you should read the first part of this series.]
  Annuities may seem a product designed for more sophisticated and wealthier investors. But LIMRA research found that the greatest interest in annuities comes from less affluent consumers who wanted to make sure their investment money lasted a long time. And while more sophisticated investors often feel annuity returns are lower than they can achieve with other retirement investments, less affluent investors seem to value the products precisely because of their similarity to Social Security.

Annuities, however, include many features that you won't find in Social Security.

Many contracts, particularly with variable annuities, have a death benefit that functions like a life insurance policy, and minimum performance guarantees as well. If you've placed, say, $100,000 into an annuity contract, you can receive a guarantee from the insurer that you or your estate will receive annuity payments totaling at least $100,000 regardless of when you die or how well the investments in the annuity perform. Other provisions may include a feature where you can lock in new minimum performance guarantees as the value of the annuity contract rises over time.

Following the 2007-08 market crash, the annuity market also took a major hit. Variable annuities were particularly vulnerable because their returns were tied to the stock market. However, many annuity purchasers included performance guarantees in their VAs called "guaranteed living benefits" or GLBs. These features are not free, but many annuity purchasers are willing to forego some upside potential in return for protecting themselves from downside losses. As the provisions of these GLBs kicked in, insurers suffered big hits because they were making good on contract provisions at the same time as the underlying values of the annuities were headed south in a hurry.

[See Crossroads for Retirement Investments Nears.]

As a result, explained LIMRA experts Marie Rice and Joseph Montminy, insurers shifted gears and have increased their emphasis on simpler VAs. These tend to include fewer investment options, lower fees, and more opportunities for purchasers to put their funds into lower-risk investments. Performance guarantees that had been optional riders may now be found inside the basic structure of many annuities. This came in response to consumer desire for safety and also can lower the cost structure of the product. Lots of newer VAs also now have what are known as dual account structures, with the option to place funds into mutual funds and into an account that includes built-in performance guarantees.

Not surprisingly, people with fixed annuities fared much better during the recession than people with VAs. There was a flight to safety, and quality, that saw a shift of funds into fixed products. Annuity sales remain well off their boom-time levels. And while VA sales perked up during the market recovery, recent market declines will put even that short-term rebound to the test.

Annuities also can be designed to provide periodic payment increases, most often to anticipate the impact of inflation. There also are annuities that don't begin making payments until the owner is old. The common trigger age for these products is 85, and they have been described as longevity insurance. You could buy one of these products at the age of 65, for example, and then plan to spend down the rest of your retirement assets by the time you reach the age of 85. Should you be so lucky to still be alive at that age, a new stream of income would be headed your way when you turned 85.

The fundamental thing to keep in mind about all these features and promises is that none of them comes for free. If you want annuity payments to continue for a minimum period, the size of each payment will be smaller than if you had no such guarantee. Ditto for payments to a surviving spouse. And for GLBs and other performance guarantees. Anything that can raise the annuity's cost to the insurance company likely will reduce the amount of money it will promise to pay you, and could entail a product fee. Guess what? Insurers are in business to make a profit. So, there is no free lunch when it comes to annuity promises. Fees may have declined but they still can be steep. Penalties for early termination of annuity contracts can be painful. There is homework to do here, and understanding product fees should be a major assignment.

All types of annuities may include surrender charges if the contract is terminated in its early years. These can be steep, the IRI says, starting at 5 to 7 percent of the funds you've placed into the annuity at the beginning of the contract and reducing to zero over a span of 5 to 7 years.

According to the IRI, most fixed annuities do not have direct expense charges. Insurers included the expenses of administering the annuity when they initially set the level of payments you will receive in exchange for your annuity premiums.

Variable annuities carry investment management fees for the VA's various investment sub-accounts. They also include insurance charges that cover the annuity's administrative expenses, and a set of mortality and expense charges (M&E) that support the annuity's payout commitments, its mortality charge for the annuity's death benefit, and the commitment that the product's insurance charge will not increase. Some VAs also charge an annual contract fee but this may be waived for larger contracts. Some states also charge premium taxes for variable annuities.

Finally, unlike banks, insurance companies do not have federal insurance backing up their annuity promises. There are state insolvency funds to make good on insurer promises. And the securities components of VAs receive some protection. But it's of course best never to have to call on such programs, so you should be dealing with a financially sound insurance company. Insurers get grades from the ratings companies. While there is justifiable heat about the strong ratings these companies gave to sub-prime mortgages and other extraordinarily risky securities, their ratings of insurers have not proven so flawed.

Still, when things got tough, many consumers turned away from publicly traded insurance companies and preferred instead to buy policies from insurance companies known as mutuals, which means they are owned by their policyholders. Generally, mutuals are more conservatively managed than so-called stock insurance companies. That may mean their products may not be the cheapest, and may not have the highest returns. But their financial stability has been winning the day lately in consumer insurance markets.

[See The 100 Best Mutual Funds for the Long Term.]