5 arguments against annuities — and how to overcome them

By John L. Olsen, CLU, ChFC, AEP, Michael E. Kitces

July 17, 2013 at 05:00 AM

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As advisors who often talk about annuities to financial advisors, we are often asked whether we like annuities. To that question, our standard answer is that we neither like nor dislike them — because they're just tools, which work well in certain circumstances and do not work well in others.

That said, there are certain arguments against annuities that frequently circulate, many of which disregard critical information or present an inaccurate summary of a complex issue. Here are five of the arguments we hear most often, and our analysis around each.

1. They're too expensive.

Perhaps the most common argument heard against deferred annuities is that they are too expensive. Usually, this criticism refers to variable contracts, as most fixed annuities assess no front-end or annually recurring charges. The costs for the insurance offered by the guaranteed living benefits of variable annuities can be, and often are, seen as excessive, and that this judgment may result from the application of investment analysis methodology to an insurance problem. One example of this misapplication appearing frequently in the financial press is the side-by-side comparison of a variable annuity with a mutual fund, assuming the same gross investment return and liquidation of the investment in a lump sum at the end of a specified period. Even where the analyst attempts to be fair and reasonable with income tax assumptions (e.g., taking into account the turnover rate in the mutual fund portfolio and the fact that not all distributions are taxed at long-term capital gains rates), assuming that both alternatives will earn a specific positive rate of return each year renders the death benefit guarantees of the annuity inoperative. Moreover, the stipulation that the investor will cash out both alternatives in a lump sum obviates the advantages of the taxation of annuitized proceeds and assumes that the annuity payout factors guaranteed in the annuity can never be of any value. The costs for these insurance features are taken into account each year by reducing the gross return assumed on the annuity by the mortality and expense charge. The potential benefits purchased by those costs are precluded from ever being realized. Such a comparison may be side-by-side, but it is not truly apples to apples.

An even more egregious example of unfairness occurs when the comparison pits a fully commissionable variable annuity (VA) against a no-load mutual fund. On the VA side of the ledger, the costs include compensation to the financial advisor, including ongoing renewal commissions. These commissions pay — not simply for the advisor selling the annuity — but for the financial counselthat the advisor renders to the investor as part of the sale. This includes the initial asset allocation and ongoing servicing, portfolio rebalancing, etc. On the mutual fund side, there are no commission costs — which necessarily implies that the investor is receiving no financial advice. In the authors' opinion, such an analysis is no more fair than a comparison of the bill presented to a client by a competent estate planning attorney with the cost of do it yourself legal software such as Quicken WillMaker Plus.^® The product in both cases may be a valid legal instrument, but the attorney's documents were informed by individual professional counseling and the attorney's client will have recourse for liabilities caused by errors or problems through the attorney's actions or work.

If the investor does not want or need any counsel, he should not be required to pay for it. But where advice is both wanted and needed — where it has clear value — both the benefit of that advice and its cost should be reflected on both sides of the comparison. Thus, if the mutual fund considered, hypothetically, of course, is a no-load product, and where the annuity cost includes compensation to the investment advisor, fairness would require that the mutual fund side of the ledger include a separate cost for advice. That sort of comparison is rarely seen.

With regard to the notion that variable annuities are too expensive, it should be noted that a few insurers have recently released contracts with verylow annual expenses. Some of these contracts offer guaranteed living benefit riders, yet their annual expense ratio is less than the typical VA.

2. They're too complicated.

The values guaranteed by living benefit provisions in variable annuities are often the result of formulas and conditions. Rarely can one point to a dollar figure and say "this is the amount guaranteed by this benefit." Perhaps most painfully, the terms under which the guaranteed amounts themselves are payable can be quite complicated. The result is a serious potential for misunderstanding and confusion, both by those purchasing these contracts and by those selling them.

For example, a Guaranteed Minimum Income Benefit (GMIB) provision may apply a guaranteed interest rate of 6% to amounts invested, to produce a benefit base from which GMIB payments will be calculated. This does not mean that the contract owner is guaranteed a minimum of a 6% return on his investment, as would be the case if the guaranteed cash value of the contract could never be less than contributions compounded at 6%. Yet the authors have heard this provision explained in just that way on several occasions — not only by policy owners, but also by professional advisors. Clearly, these individuals had no idea how the GMIB provision they were describing actually worked. Jack Marrion, in a recent study of Guaranteed Living Benefits, writes that he has received many emails from VA purchasers who state that "they were receiving, or were told they would receive, a guaranteed 7% a year payout for 14 years and then they would still get at least 100% of their money back at that time," despite the fact that the GMWB guarantees only that 7% payment for 14 years.

In the authors' view, this is potentially a very serious problem, for both advisors and their clients. Any competent decision as to whether a guaranteed living benefit is worth, to a particular client, what the insurer charges for it necessarily requires that all parties to that decision fully understand what they are assessing. Some insurers, recognizing this, have instituted special training programs to ensure that those recommending these complex products understand them. The NAIC has also recognized this problem, and included, in its Suitability in Annuity Transactions Model Regulation of 2010 (SATMR), a mandate that agents recommending any annuity complete a four-hour continuing education course specifically devoted to annuities (see discussion of SATMR in Chapter 14). In the authors' experience, far too many agents selling annuities do not thoroughly understand the complexities of the annuity contracts they are selling, and the SATMR-required training is long overdue. Some, but certainly not all, agents know about the products they offer only by what they read in point-of-sale brochures and hear from product wholesalers. Far too many have never read the annuity contracts.

Similarly, many advisors fail to understand the complexity underlying at least some types of equity-indexed annuity contracts. Although some use formulas that are relatively straightforward and easy to understand, others do not. A failure to understand the implications of crediting formulas in allpotential return environments — not simply the one illustrated in the marketing materials, which is often not merely an average scenario, but an optimal one — can lead to a mismatch between client expectations and reality.

The authors strenuously recommend a serious study, both of the marketing brochures and the actual contract language describing policy provisions — especially, the descriptions of guaranteed living benefits for variable annuities and the crediting formulas for equity-indexed annuities — to anyone who intends to provide recommendations regarding annuities with such provisions. We also recommend that any advisor who intends to sell, or offer advice concerning these benefits take advantage of special training classes on the subject, even if these classes are not yet mandated in the states in which they work.

Guaranteed living benefit riders, and equity-indexed annuities, when properly understood, can be of significant value to many clients, but both advisor and client must be capable of wading through the complexity to know what the annuities will, and will not do. It's not impossible to understand the sometimes complex provisions contained in annuity contracts. Although, arguably, there are a few exceptions where the contracts are so complex only that the actuaries who designed them may ever fully comprehend how they work! If an advisor and their client are not willing to get a handle on the complexity involved, it may be better to select an alternative route.

3. Annuities should never be used to fund an IRA or qualified plan.

A generalization often made about annuities claims that they should never be used to fund an IRA or qualified plan. This sweeping pronouncement has met with surprisingly wide acceptance among financial journalists, attorneys, accountants, and many financial planners. It has become virtually accepted wisdom for many, despite the facts that: (a) it ignores the huge differences that exist between immediate and deferred annuities and between the fixed and variable varieties of the latter; and (b) the arguments most commonly made in its support are grievously and obviously flawed.

Those who argue that annuities are inappropriate instruments for funding IRAs or qualified plans are almost always referring to deferred annuities, and, usually, to variable deferred annuities. The three most common of these arguments are:

1. "You're paying for tax deferral you're not getting." This is simply nonsense. While it is true that an annuity offers no additional tax advantages over any other investment vehicle when used to fund an IRA or qualified, no annuity assesses any charge for the benefit of tax deferral. To be sure, variable deferred annuities impose charges that alternatives such as mutual funds do not. Those are, as we have seen, insurance charges. They have absolutely nothing whatsoever to do with the tax treatment enjoyed by the annuity. The tax treatment of an annuity used to fund an IRA or qualified plan is identical to that applicable to any other IRA investment. The treatment which would apply to a deferred annuity, if it were not used to fund such a plan, is irrelevant when the annuity is so used.

The insurance charges of a variable deferred annuity may or may not be worthwhile to a particular investor, based upon that investor's need for the risk management benefits the charges pay for; but this is true whether the annuity is funding an IRA or is a nonqualified annuity. If the insurance benefits are not worth the cost to a particular client, then they should not be paid for, whether the money in question is qualified or not.

2. "The tax deferral of an annuity used to fund an IRA is wasted." This one is doubly flawed. First, because the tax deferral enjoyed by nonqualified annuities flows from provisions of the Internal Revenue Code that apply only to nonqualified annuities, that deferral cannot be wasted by an IRA annuity because it does not apply to an IRA annuity. Second, the argument rests upon an assumption that the tax treatment which a particular type of investment property would enjoy if it were held in a taxable account is somehow relevant to whether it is an appropriate funding vehicle for an IRA or qualified account. To illustrate the absurdity of this assumption, let us consider the question of whether small cap growth stocks, or a fund investing in these stocks, might be appropriate for an IRA. The investment returns produced by these stocks, or funds, will generally be taxed at long-term capital gain (LTCG) rates if held for longer than one year. LTCG rates are, of course, significantly lower than the rates for ordinary income. Inasmuch as all non-Roth IRAs and qualified plans, except for basis, are taxed at higher ordinary income rates, it would follow that funding an IRA with small cap growth stocks—or a fund investing in the same—would be a waste of capital gains treatment. Obviously, the appropriateness of a small cap growth stock for an IRA or qualified plan has nothing to do with how it would be taxed if it were held otherwise. The same holds true for an annuity.

Furthermore, a small cap growth stock held in a taxable account receives the same tax-deferral benefit as one held in a retirement account, if you assume that it is held until some future point when it is sold or liquidated for a lump sum, as is commonly the case with annuity comparisons. Although individual stocks can be held indefinitely, with no recognition of annual gain until liquidation—not unlike a nonqualified annuity—one rarely sees arguments that stocks are an inappropriate investment for retirement accounts, despite the fact that the tax benefit of holding individual stocks outside of a retirement account is even more beneficial than that applying to a nonqualified annuity. This is because the stock receives preferential tax treatment; through the application of LTCG rates, and the opportunity for a step-up in basis if held until death. To the extent that it is clearly inappropriate to suggest that retirement accounts should not hold individual stocks because of the benefits foregone by not purchasing them in taxable accounts, the same holds true for annuities.

3. "They're too expensive." As we have said, if the insurance benefits of the annuity, which are the source of the excessive costs cited by critics, are neither needed nor wanted, they should not be purchased. A deferred annuity, especially a deferred variable annuity with guaranteed death and living benefits, is chiefly a risk managementtool. If the risk management features are not desired, an instrument providing and charging for them is, indeed, too expensive. If they are desired, the charges for them must be viewed for what they are—insurance costs.

4. Annuities are sold mostly because of the high commissions they pay

This argument may be accurate to some degree, but it is also an ad hominemlogical fallacy. It is true that the commissions paid on deferred annuities are often higher than those paid on mutual funds, and common sense suggests that a commissioned advisor, in choosing among alternatives to recommend to a client, will be influenced by the amount of compensation each alternative provides him. However, the benefit of any investment to its owner consists in what can be realized from it. The value of that investment must, of course, be reckoned by relating the benefits received to the cost paid. If a deferred annuity offers benefits not available from alternatives, but its cost to purchase and maintain is higher, the value of that contract depends upon whether the additional benefits are worth the additional cost.

A particular annuity contract that pays 3.5% of the investor's contribution to one selling agent, but 6% to another — because those agents have different contracts with their respective broker-dealers — will have the same value to the purchaser, assuming that the advisors are equally competent and diligent. The agents' commissions will be of significance to those agents, and, arguably, may affect their recommendations. But the value of that annuity to its purchaser will be the same, whichever agent makes the sale.

The value of the annuity relative to its costs depends on the features and benefits of the contract and the costs to the client, regardless of where or how those costs may be subsequently allocated. As an extreme and entirely imaginary example, consider an investment that charges the purchaser an overhead cost of 5% per year, but provides a guaranteed return of between 15%-25%. Although the annual cost of the investment is absurdly high, so is the return. This would probably be an extremely good investment, if it existed. Moreover, the decision as to whether this is or is not a good investment depends solely on the costs and benefits of the contract. Whether the issuer uses the 5% per year it collects from the purchaser to compensate a salesman with 2%, 5%, 10%, or 20% of the purchase price has no bearing on the value of the investment to the client.

Some annuities do not pay commissions and generally offer lower charges as a result. These low load contracts account for only a small fraction of the annuities sold each year. Does this mean that most annuity purchasers are being abused? That conclusion does not follow, for two reasons:

1. The guaranteed death benefits, and especially the guaranteed living benefits offered by low load, deferred annuity contracts are often less attractive—though, of course, less costly—than those offered by fully loaded annuities. Where these guarantees are important to the client, the lesser benefits offered by low load contracts may be unattractive, even if the annuity includes a total lower annual cost.

2. Noncommissionable products are sold chiefly by fee-based or fee-only advisors who charge for advisory services. When adding the advisory fee to the annual cost of a low load annuity, the resulting total annual cost—while it may or may not be less than the annual cost of a fully-commissionable contract—may still be unattractive, as the benefit of that cost will be limited to the generally less attractive guarantees of the low load annuity.

5. Only 2% or a low percentage of deferred annuities are ever annuitized.

There are two flaws implicit in this argument. First, the right to annuitize is just that — a right. It is not an obligation. The opportunity to avail oneself of either the payout factors currently available to holders of a deferred annuity, or to elect annuitization using the factors guaranteed in the contract, is just that. It is an opportunity, a choice, and a risk managementdecision, much more than an investment one. A decision not to exercise an option does notmake the option valueless.

An even more serious flaw to this argument is that it is a statistic which is utterly unreliable. Even conceding the accuracy of data on annuitized contracts, the flaw lies in the definition of annuitized. That term means an election, by the owner of a deferred annuity contract, to accept an annuitization option in that contract. In that literal sense, the statistic — of 2% or whatever percentage one happens to use — of contracts that are annuitized may be accurate, but it is entirely meaningless as an indication of how many owners of deferred annuity contracts have chosen to convert their accumulated value to an income stream.

One of the authors has been selling annuities for over 38 years and has very rarely recommended that a client exercise any annuity option in his contract. He has recommended to many clients that they exchange an existing deferred annuity for a single premium immediate annuityfrom whatever highly rated insurer happened, at the time, to offer the highest annuity payout rate for the option chosen. But, as it occurred, the current annuity payout rate in the client's existing deferred annuity was almost never as attractive as the payout rate in a competing company's SPIA.

This procedure (i.e., going shopping for annuity rates on behalf of a client, and recommending a tax-free exchange of that client's existing deferred annuity for an immediate annuity) is a very common practice. It could be argued that the failure to offer this option to a client constitutes a breach of advisor responsibility, since by accepting a payout rate higher than the one guaranteed in his deferred contract, the client cannot fail to benefit so long as the issuer of the immediate annuity is at least as financially strong and viable as the issuer of the deferred contract. These exchanges are done every day both because they are in the client's interest and because the agent selling the immediate annuity earns a commission. They are not reflected in the statistic quoted above. It is certain that the total number of annuity contract holders electing to convert a deferred annuity to an income stream—a number that must include both annuitizations and exchanges of deferred annuities for immediate ones—is far higher than the 2% or so reported. How much higher is anyone's guess.

For more content from The Advisor's Guide to Annuities, see:

5 arguments in favor of annuities

Which indexed annuity is right for your client?

5 prime annuity prospects

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

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