Episode 217: The Annuity Debate: Smart Strategy or Overpriced Product?

Introduction to Annuities

Alex Murguia 00:02

Hey everybody, welcome to Retire with Style with our continuing episode on Wade's new release, the third edition of the Retirement Planning Guidebook. We're going through the major questions that this book will answer for you and in today's episode we're going to focus on the A-word. What's the A-word, Wade?

Wade Pfau 00:28

Probably you mean annuities, but I'd have to double check on that. But yeah, and also just to note, with some of our past in-studio episodes, the audio quality was not very good, so we are re-recording at this point. If you're watching us on YouTube, we're back in the home studio. Got away from that audio quality. So that should not be an issue in any of the subsequent episodes here.

Annuity Fundamentals and Risk Pooling

Wade Pfau 01:35

Okay, alright, so let's get right down to it. What's the scoop on annuities? Are they worthwhile? This is about chapter five of the retirement planning guidebook, which covers the topic of annuities, risk pooling, insurance and retirement. We talked a lot about the retirement income styles and annuities are tools that fit well in particular with certain retirement income styles may not be as relevant for other retirement income styles. But if you do have a retirement income style that views annuities as a worthwhile tool, it mainly relates to the actuarial science idea, the power of risk pooling, the insurance that they provide, that you're combining your premiums with a large cohort of individuals. No one in that group knows how long they'll live, but the insurance company can use the law of large numbers. There's thousands of people, thousands of customers in that pool to know that roughly, say 90% of their people in that pool will live past a certain age. 10% might live to age 100. They can figure out pretty good terms that they don't know who's going to survive to a particular age, but they know what percentage of the customer base will survive to a certain age. And that allows them to pay at a much higher level than individuals might otherwise feel comfortable spending if they have to self-manage their own longevity risk. And so that's really the basic idea behind annuities, that they can provide that risk pooling potential to help support guaranteed lifetime income and retirement. So in that regard, yeah, they're absolutely worthwhile. You've got the investment growth and you have risk pooling and insurance as two alternative means to help fund retirement in the face of longevity and market risk.

Pro and Con Arguments

Alex Murguia 03:23

Well, wait, that all sounds great, but I want you to provide the two perspectives that folks commonly hear from the, let's say, your cocktail party guy who knows everything about personal finance because they watch CNBC 24-7, and the advisor, one way or another, that's always trying to sell you something. You know, for annuities, where it's the panacea, or against annuities, where it's kryptonite to your financial health. What arguments are they usually making and what's the remedy for that where it's like, well, not so fast.

Wade Pfau 04:10

Okay. Well, yeah, on the against annuity side, I think for the most part, people are treating them as an investment and then rather, and if you do think about them as an investment, it's probably better to compare them to bonds rather than to stocks. But it's always like, well, the stock market will do much better than the annuity. So therefore it's a bad investment and annuities can be laden with high fees, high charges. So you really just paying a lot for an investment that's going to underperform. That's generally how the argument against annuities is made. And the point there is it's not really thinking about from the context of retirement income planning. It's just thinking about an accumulation-based portfolio. Let's build an asset allocation and grow our wealth and then not really viewing annuities as a good growth and accumulation vehicle, which fair enough, that's really not the point of them. They are meant to provide those guaranteed payments, which can be over a lifetime in retirement.

Wade Pfau 06:29

Now to the credit of the anti-annuity crowd, annuities in many ways have lost that sort of notion that this is what they're for, to provide guaranteed lifetime income. They get used as tax deferral vehicles in the context of accumulating assets. And so I think that can lead to confusion where people end up, well, if they're being treated as investments, let's analyze these investments and they don't look like good investments. But again, from the retirement income context, that's not really what we're thinking of. We can talk about, with certain retirement income styles, there might be an application as more of an accumulation-based tool. But for the most part, we're thinking of them more for that lifetime retirement income planning. And then for the crowd that's perhaps too pro-annuity, or is like, you need an annuity for everything, and that's all you need. Well, there are many kinds of annuities out there. The strongest marketing would be for something like a fixed index annuity with a living benefit where the overly optimistic marketing messages you get like the growth of the stock market without any risk of the stock market and you get a guaranteed lifetime income. And so now they're being compared to stocks. That's not really the right way to think about them either. You do not get the growth of the stock market without the risk of the stock market. You can expect annuities to have returns that are more in line with bonds or other fixed income alternatives, then if they do provide that guaranteed lifetime income, that's really the motivation behind it. But it's not a tool that's going to give you stock market growth without any risk. So you got to find that middle balance between those two positions.

Fixed vs Variable Annuities

Wade Pfau 07:45

Well, yeah, I guess here we do need to start to talk about different types of annuities. You've got fixed annuities and you have variable annuities. And fixed annuities are mostly spread products where you don't actually have any observable fees. It's just internal. It's just like if you put money in a bank. If the bank pays interest on your checking account, the idea is they're paying you less interest than they can earn. They may go out and loan your money at 6% and then pay you a 2% interest rate. The spread is how they're making their money. They're able to earn more on your assets than they're paying to you. And so that's what a spread product would be with an annuity. The idea is if there are no internal feed drag or no internal need to support the company that's creating that product, then you might get a higher yield or a higher payout rate, more lifetime income. But the idea is you're not getting the full actuarially fair value. The insurance company is going to be taking something out internally. It's just that's not an observable fee other than with optional guaranteed lifetime withdrawal benefits. Then fixed annuities might still have an observable fee for that optional benefit. Mostly when people talk about annuities being high fee, it's more on the variable annuity side.

Wade Pfau 09:32

Where you have variable annuity, where you're investing in sub-accounts, and then you have fees on those sub-accounts that work a lot like mutual fund fees. Just the different investment strategies, they're a lot like mutual funds, except they're technically not called that because they're inside of annuities. But yeah, you might have a stock market like S&P 500 sub-account, a bond sub-account, different investment options, each with their own fee drag. And then there's annuity fees on top of that. There's an mortality and expense charge, which is funding the insurance company and funding commissions if they're paid to the advisor and so forth. And then there could be optional living or death benefits that when you add those all up can get you into that three or 4% range in some cases.

Wade Pfau 10:06

Right, and that insurance charge is helping to support the death benefit, which would just be any remaining assets. But also any annuity can be annuitized. This is now getting into some other vocab that we have to kind of break down based on how annuities work today. But if you annuitize the contract, that means you're converting it into a series of payments. These days, a lot of annuity contracts never get annuitized. But yes, part of the insurance expense and the annuity is supporting the idea that you are allowed to annuitize it if you want to. Living benefits can provide an alternative way to get guaranteed lifetime income without having to annuitize the contract. So that's where things can start to get more confusing. But the insurance costs are supporting that ability to annuitize the contract.

Longevity Credits and Mortality Credits

Wade Pfau 14:04

Yeah, and in the third edition of Retirement Planning Guidebook, I renamed Mortality Credits to Longevity Credits, because it's really a credit for living a long time. It's a credit you get from the mortality of others. I think Longevity Credit just explains the concept a little more clearly. But yeah, another way to think about all this, the kind of the baseline for how you could fund your retirement is you could build a bond ladder. You have bonds maturing each year, and if you want to plan for a 30-year retirement, you could build a 30-year bond ladder. And then the bond yield curve, the interest rates tell you exactly how much you'd be able to spend over that time horizon. If you then live beyond 30 years, you don't have any money left at that point. You would have spent down your bonds entirely. So you've got two options to try to spend more than that. The total return approach, build an aggressive, diversified investment portfolio, and rely on the risk premium from the stock market to support a higher level of spending throughout retirement. Or the safety first or income protection approach is use the power of risk pooling and longevity credits or mortality credits to support a higher level of spending the bonds.

Comparing Annuities to Bonds

Wade Pfau 16:52

And it's, well, there's different kinds of annuities. The simple income annuity, you pay a premium to get a guaranteed income for the rest of your life. And for the most part, the insurance company is taking that premium, investing it in their general account, which is primarily a fixed income portfolio. But that's earmarked more for long-term, like less liquid bonds with longer maturities, potentially a little more credit risk because of the diversification to get a higher potential fixed income yield than the household could get on their own, but primarily a bond portfolio. And so part of the payout rate reflects the interest that the general account can earn. And then part of the payout rate reflects the mortality credit idea. The idea that the insurance company, like, I may live beyond my life expectancy. If I plan for a 30-year retirement, it's like 65, planning to live to 95. For bonds, I'd have to spend a lot less than the annuity can support because the annuity can pay everyone as though they live to their life expectancy. Half of the people don't live that long. Half the people live longer. But just roughly speaking, everyone can spend as though they live to their life expectancy because they know they have that mortality credit or longevity credit backing their retirement. The longer they live, the more spending they can support through the annuity. And that's the alternative way to potentially spend more than just with a bond portfolio. But the comparison is more to bonds, not to stocks. Now, they can be competitive with stocks for people who live a long time, but really it's a way to outperform bonds, just like stocks are a way to outperform bonds. And you then have options about which of those you feel more comfortable with for meeting essential expenses in retirement. And the idea that the annuity is not an all or nothing thing. It's I build a floor of reliable lifetime income, and then I can invest on top of that. And that's where the stock market comes into play for more discretionary types of goals, not for my essential expenses.

Immediate vs Deferred Annuities

Wade Pfau 18:40

Okay, yeah, in the book, I start that discussion by talking about four broad categories. Annuities can either be immediate or deferred, and fixed or variable. And it can start to get confusing though to try to frame them that way. Right. And then another issue is the immediate or deferred aspect can refer to two different things. Well, let's maybe we'll start with fixed versus variable since that's less confusing probably.

Wade Pfau 19:27

Well, that's an immediate versus deferred part. So well, fixed versus variable. Fixed annuities provide principal protection so that you're not at risk of losing money within the contract, than if you had, assuming you haven't annuitized it, we'll get into in a minute. And then variable is, there's a risk for loss. So they're treated as securities and that's traditionally you could invest in different sub accounts. But that sort of approach is becoming less common. And now the registered index linked annuities are variable annuities because the buffer annuities, maybe there's some sort of buffer that protects against some downside risk, but you do still have downside risk beyond the buffer. So that would be a type of variable annuity. So fixed principal protection, variable, no principal protection. And then immediate versus deferred can mean two different things, but the more accurate or technical meaning is an immediate annuity means you've annuitized it. You've flipped the switch to convert the value of that annuity into a series of contractual payments, either for a fixed period of time or to be life contingent, to continue on the contingent on the survival of the annuitant in the contract. And the deferred annuity is you have not annuitized it. You still have access to the underlying contract value, you can make decisions. Now that if you want to get the full money back in the early years of the contract, there may be surrender charges. But if you have a deferred annuity that you hold for long enough, so you get past a surrender charge period, it becomes in a way fully flexible at that point that you can have all your funds returned.

Fixed Index Annuities and MIGAs

Wade Pfau 21:29

And that's a deferred annuity. So like a simple income annuity, in terms of now going through the different types of annuities out there, that's a fixed immediate annuity. It's an immediate annuity because you're annuitizing the contract, you're taking the premium and converting it into a series of lifetime payments. And it's a fixed annuity, really because there's no like sub-account investments here. In the case of an immediate annuity, because you've annuitized it, you don't have access to the contract value anymore. But that contract value, the premium that you paid is just part of the insurance company's general account. The other main kind of fixed annuities would be on the, well, MIGAs, the multi-year guaranteed annuities, or the fixed index annuities. Those are the annuities that have principal protection and link their credited interest to some external market index, such as maybe the S&P 500 would be the most common one. Not the total returns of the market, but the price returns with dividends removed, since these are based on financial derivatives that don't pay dividends.

Wade Pfau 22:35

There's a lot of different potential designs. The most common is probably there's going to be a cap. So I look at the price return on the S&P 500 with dividends removed. If the price return was negative for the year, or if I have a one year term, so to speak, if the price return was negative, the annuity would credit zero for the year. If the price return was between zero and its cap rate, maybe six or 8%, I'd get 100% of that up to the cap. And if the price return was higher, I would be credited with the cap rate. Just the number that if the price return was greater than that you would not get any more so if the price if the market was up 20% and you had a cap of 8%, you would be credited with 8% for the year.

Living Benefits and Guaranteed Income

Wade Pfau 24:28

Yeah. So then variable annuities also have immediate types and deferred types. Immediate variable annuities are incredibly rare. And I do explain them in the book, but they're so rare, we probably can skip them for the podcast. Deferred variable annuities are the most common. And that's where you could either treat it as an accumulation tool where you've got this deferred annuity, you're making investment decisions, or if it's a registered index linked annuity, you're deciding which index to link to and so forth. But you've got some flexibility there and it's deferred. And also the same with a fixed index annuity. It's a deferred annuity, but then if I add an optional guaranteed lifetime withdrawal benefit, that provides a structure around how much I'm allowed to distribute each year. And if I don't exceed that amount, should the contract value for the annuity ever deplete because I've spent down all my assets? Then it enters a settlement phase where it will continue to pay a guaranteed income for the rest of my life based on the terms of that living benefit rider. And so that's usually how people are getting lifetime income these days. The income annuities are not as commonly used. They do provide lifetime income. They're annuitized contracts. But the more common approach these days is I would apply an optional guaranteed lifetime withdrawal benefit to either a deferred fixed annuity such as a fixed index annuity or a deferred variable annuity, such as a registered index linked annuity or a traditional variable annuity with sub-account investment choices.

Wade Pfau 26:35

Yeah, it sounds right. It's an optional living benefit writer says how much I'm allowed to spend each year. And it has provisions where if your portfolio, if the sub accounts grow, you might be able to get a step up to even have a higher guaranteed income. But as long as you don't take out more than that, you're spending on your own account. And unlike mutual funds or traditional investments, should that account ever hit zero, that then triggers the annuitization where the insurance company is now on the hook to continue those payments for the rest of your life.

Life-Only and Cash Refund Annuities

Wade Pfau 27:53

Yeah, so that would be a life only income annuity. And those are not common, but they tend to have the highest payout rates potentially just because you accept the most risk. You're offering the most mortality credits to the risk pool, that if I die early, all my leftover premiums will go to other people in the risk pool. And so in exchange, you get a higher payout rate for that. But most people aren't comfortable taking that route. So the more common approach would be to have a cash refund provision, where you get that guaranteed income for the rest of your life, if you pass away before the original premium has been returned as annuity payments, a cash refund of the difference between the premium you paid and what you received thus far would be provided to your beneficiary. And so that takes away some of the risk of like, if I sign the contract with the cash refund, get run over by a bus when I leave the office, well, then the cash refund provision would then become the death benefit to my beneficiary. And so I'm taking less of that type of mortality risk. And therefore it's going to have a lower payout rate because I can't expect to get as much back from the risk pool since I didn't put as much into the risk pool. Now, for the most part, it's not that hard to outlive the age where you get all your premiums back. Most people will, most annuitants will. So it's not going to be that big a difference in the payout rate. But the payout rate will be less. However, you do need to shop around because a lot of companies don't even offer life only annuities. And so the best in class annuity with a cash refund might actually have a higher payout rate than the best available life only income annuity, just because there's a more competitive company offering the cash refund provision.

Wade Pfau 30:21

Yeah, it could be that there's an element of marketing or some companies, they may just not want to, they also, they're looking at their life insurance portfolios and trying to hedge that as well. So if you're selling both life insurance and annuities, that helps you manage systematic changes in longevity. Like if suddenly people live five years longer, well, your annuities will pay out more, but your life insurance will pay out less. So you're kind of hedging that risk for yourself. Companies may just be able to offer more competitive terms because they're better hedged with the life insurance portfolios and so forth. Now the risks, and this is where it's very rare for insurance companies to not pay the promised benefits. It's happened a few times in history, but that's generally been smaller companies who may have been just pricing to get the sales, not really the best potential companies. So you do want to look at credit ratings, credit quality to choose highly rated companies. And then also when you're looking at fixed annuities, most states offer a state guarantee association where as long as the premiums are up to a certain threshold, the state guarantee association will support those payments should the insurance company default.

Tax Deferral in Deferred Annuities

Wade Pfau 32:39

Yeah. Yeah. So there's one more detail we need and then we can walk through the map and it's just so annuity deferred annuities provide tax deferral. Just like an IRA does in terms of you're not paying ongoing taxes on the growth. You pay the taxes. It comes out as ordinary income when distributed from the annuity. And so if I'm thinking about like, do I have my money in a taxable bond fund or in an annuity, the annuity is also providing tax deferral. But if you're using it for lifetime income, there's gotta be some other reason because you're not uniquely getting tax deferral. You already had tax deferral inside of a tax deferred retirement plan. So there's gotta be some other reason to consider the annuity. And that could be because you're using it for lifetime income, or it could be if it's like a registered index linked annuity, you like the characteristics of its return potential. But yeah, there's gotta be some other reason. Tax deferral is not a reason to get inside of a tax deferred account because you already have tax deferral anyway.

RISA Profiles and Annuity Matching

Wade Pfau 35:44

Yeah, yeah. So then like with the total return individual, they're the least likely to be interested in annuities, to be quite frank on the point. If there is a role for annuities, it's going to be at the margins either. There are low cost, they're called investment only variable annuities. You have to really focus on having low cost. They're going to be variable annuities, mainly with sub account options where for your less tax efficient investment choices they provide you a way to get tax deferral. And you're probably never going to annuitize the contract. You're using it more as a tax deferral vehicle. And the costs have to be low enough so that costs don't eat up any of the benefits of the tax deferral. Then also, just from a purely accumulation-based mindset, there can be interesting applications for things like registered index linked annuities as part of a portfolio for total returns individuals. But that's about it. They're not going to be looking at them for lifetime income. Generally not going to be looking at them for the most part, but if there is an application that's where it would lie.

Wade Pfau 37:25

Yeah, yeah, MIGAs are deferred fixed annuities. They pay a fixed interest rate. A fixed index annuity is paying anywhere between zero and the cap, or there's many designs. But a rate that fluctuates based on the performance of the index, a MIGA just pays a fixed rate and has the tax deferral. So you're getting a tax deferred fixed rate that you compare to your other fixed income options.

Wade Pfau 39:24

Yeah, well, income protection and risk wrap on the bottom half of the RISA matrix. That's where annuities for lifetime income will enter the conversation. Income protection is the classic a flooring approach. And that's more what annuities offer the highest payout rates. I'm not really going to look at the upside growth potential for the contract. Not necessarily worry too much about the idea that I could get step ups and higher income. I just want what's going to give me the most income if markets don't perform all that well. And that's usually with fixed annuities, whether it's the income annuities, single premium immediate annuities, deferred income annuities, the QLAC qualified longevity annuity contracts. Those are all types of immediate annuities, which just means they're all contracts that are annuitized right away. So you've got those, and then you have the fixed index annuities with living benefits, which in theory, should have lower payout rates than immediate annuities. But in practice, that's not always the case. And that's just due to sometimes people buy those optional benefits and don't use them. And so they're not getting the full value out of the contract. That makes it easier for the insurance company to raise payout rates within the contracts. So they can be competitive with income annuities.

Wade Pfau 41:17

And then on the risk graph side, so that's now probability based and commitment oriented. That's more a conversation around variable annuities with living benefits, whether it's traditional variable annuities with living benefits or registered index linked annuities with living benefits, where there's more potential that the payout rate might be lower so that if markets don't do all that great, I may get less guaranteed income, but there's growth potential. There's step up opportunities. If markets perform well, I may be able to support a higher average income from that annuity than I could get from a fixed annuity. And that's why variable annuities become more a tool on the risk-wrap side of the spectrum.