Pennsylvania Investment Observer

A Few Notions About Annuities

by Daniel J. Nestlerode

In the throws of the current stock market decline, many investors are buying annuities to protect their principal and earn a seemingly fair return. Yet, many investors and investment professionals are falling into a trap that will, perhaps, become the source of investor dissatisfaction and legal wrangling in the future. Yet, you might ask, how can a "guaranteed" investment be the source of investor dissatisfaction? The answer lies in the outcome when the investment turns out to be something other than what was expected by the investor. Investor dissatisfaction, it turns out, is usually spurred by unexpectedly poor investment performance. When the returns do not come from the markets, some investors turn to the regulators and their lawyers to help make their portfolios whole. So what are the problems with annuities?

First, there are no "guaranteed" annuities! Insurance companies issue annuities. How an annuity performs depends upon how well the insurance company does with its investments. Simply put, annuity performance is based on the performance of the underlying investment portfolio run by the insurance company. The so-called "guarantee" is based on the issuing insurance company's investment performance. If the insurance company fails, so do the annuities it issued. There is no federal insurance backing or guaranteeing any insurance company or any annuity product. So an annuity doesn't necessarily protect you the investor, from the performance of the stock market or failures in the bond market. Furthermore, insurance companies do fail. Recently Conseco, a large multi-line insurance company filed for bankruptcy. So when you hear the word guaranteed related to annuities, pay attention. "Guaranteed" in annuity terms is a sales tool designed to spur sales. In short, annuities are not guaranteed in any meaningful way.

Second, you cannot know ahead of time or even after you have put money into an annuity the risks you are taking. Annuities are not transparent in terms of disclosure of the underlying investments that back the annuity. If you cannot know the investment managers, the investment policies of the insurance company and the portfolio of investments in which they have committed money, you cannot assess the risks you are taking making such a purchase. Indeed, most annuities are blind investment pools, never relating to the purchaser what they have really bought. You would not buy a car this way. So why do investors fall for buying blind investment pools? Because they were told the product was guaranteed! The real question is guaranteed by whom. The answer is by the issuer. To knowledgeable investors this is a no pass. In investment terms this means that annuities are not "transparent".

Third, annuities seemingly offer tax benefits, as the accumulation within the policy is generally tax-free to the purchaser during the period when the returns are accumulated in the policy. However, when the investor wants to spend some of the returns, the purchaser will pay income tax on the gains in the account. Further, if the purchaser passes away while owing an annuity, the beneficiary will be taxed on all of the accumulated earnings from the date the annuity was purchased as income. There is no step up in tax basis for annuities for estate purposes!

Fourth, annuities are expensive. Annuities are not investments, but are insurance products. However, sales people dress up annuities as investments because they are easier to sell as investments than as insurance products. The average annuity charges purchasers about 2.25% of his or her investment annually, in addition to sales charges when the purchase was made. Part of the annual management fee goes to investment management fees and part is related to the life insurance on the purchaser. If you pass away the insurance company will pay, if it is financially able, the annuity beneficiary the current value of the policy or the face amount of the policy, whichever is more. In the past few years, this benefit has cost insurance companies dearly. One large well-known insurance company took a $700 million loss on annuities sold in the past few years where the owner had passed away. Annuities are often sold based on this investment guarantee! If your account is worth less than you have invested, the insurance company will pay your beneficiaries the amount you invested. Unless, of course, the insurance company has filed for bankruptcy in the mean time. Of course, since annuities have no investment transparency, you won't know if your investment is in trouble until you file a claim. Too late, as they say. But I digress. The investment return on annuities is based on the returns in the bond markets (if the annuity is fixed) or the stock market (if it is a variable annuity). So, your annuity will pay the gross returns of the bond or stock market less the cost of the annuity (5% or more up front) and 2.25% per year forever if you have an average annuity. In a market that offers 5% on government bonds, how much can your guaranteed fixed annuity really pay to you? And if the stock market is falling, how much will your variable annuity pay to you? The answer is about 3% on fixed annuities backed by quality bonds. Tell me how the stock market, and I'll hazard a guess on the performance of your variable annuity.

Now that you understand that you cannot avoid investment risk by the purchase of annuities and that they are not really a guaranteed investment, how appealing do annuities seem to you? And if you do not understand the details of annuities, do you think some policyholders will file legal actions to recover their investment?

I have analyzed annuities lately by following the money. If you invest $100,000 in an annuity, many insurance companies offer returns of 10% on the first year you invest and no deduction for the sales charge. They are offered commission free. That is why the earnest agent is sitting in from of your trying to make this sale. Insurance and investment agents do not sell products for free. Neither do insurance companies give money away because you, the client, are such a nice person. Insurance companies make money selling annuities. Lots of money. So how does the insurance company pay the agent and give you a return of 10% when no quality investment is paying over 6 to 7%? First the 10% first year bonus earnings is only paid if you hold the policy for years and accept your returns as a series of essentially equal payments. You cannot cancel your annuity after one year and have a 10% return on your money and your original purchase price back. The insurance company pays the agent five percent or more when you buy your policy. This comes out of your money. So too does the bonus first year return because there is no other place to get the money. Certainly not from the investment markets. All returns on annuities come from the investment markets or are a return of the purchasers funds relabeled as a sales tool to get you to buy.

These issues and others lead me to believe that in future years a large group of dissatisfied purchasers of annuities (as investments) are going to find a good lawyer and file a law suite. Recently Wall Street agreed to pay over a billion dollars to regulators for conflicts of interest related to investment research provided to retail customers. Many individual investor lawsuits are following the settlements with the regulators. In my thirty-seven years on Wall Street, we have known all along that "research" issued by Wall Street firms was really "sales material designed to induce a transaction". Yet disgruntled regulators and investors hurting from a falling market are now looking to the courts to help their investment performance. I am convinced that in the coming years dissatisfied annuity purchasers are going to look to the courts to redress shoddy sales practices and misleading claims of "guaranteed" investments.

I have not address all the characteristics of annuities and when they might be a useful purchase. Clearly there are circumstances where annuities might be the right purchase. However, they are not the cure all for a poorly performing stock market.

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