The Annuity Epidemic: Lazy Financial Advisors And Shady Insurance Companies Are The Disease
June 6, 2014 by Ryan Wibberley
Some financial talking heads, like Suze Orman, pontificate about annuities and would have you believe they are all bad, for all people. This is complete nonsense. Nor are they a good idea for all people. Like any investment, before you put one cent into it, you need to understand it or employ a competent financial advisor who can explain it to you clearly and simply. And if your advisor can’t do that, or you leave a discussion about something like annuities as confused about things as when you first asked your question, I have news for you – you need to re-evaluate your financial advisor. Consider your financial advisor as you would your doctor – one makes recommendations and offers answers regarding your physical health, the other, your financial health. In either case there is no excuse for a lack of ability to clearly articulate your options as either patient or client.
When it comes to annuities, the epidemic we’re facing now has less to do with the investment vehicle and more to do with advisors who aren’t fully aware of all of the details pertaining to the annuity contract and how it will impact you. The world of finance is constantly manufacturing products to attract your assets into their proprietary investments and the annuity is a perfect example. About 10 years ago, annuities went through a transformation – from being a fairly simple insurance based investment account that provided for tax deferral and the safety net of a death benefit, to a significantly more complex product with many more bells and whistles. Opponents of the insurance industry claim that fees were too high, but proponents of the annuity stated that the benefits of tax-deferral far outweighed the higher fees.
The annuity of today, in addition to tax-deferral and a death benefit, will have “living benefit” features available, which may allow for a lifetime income for you, your spouse, or both. It may have some sort of enhanced death benefit feature, where the death benefit will constantly increase with the market. It will most likely boast some sort of guaranteed increase in dollar value or that your investment performance will never be negative or it might have a “high watermark” that the value will never go below. Some annuities even offer long-term care benefits. On the surface, it would appear that if you were to buy an annuity, you would have all of your financial bases covered. Not so fast.
Let me start by saying that, there is no doubt in my mind that these features are helpful to some people, even though the fees are high. My problem with annuities is that many investors and their advisors don’t fully understand the contracts they are entering into, and the insurance companies do not help, by making them so difficult to understand. Investors could be paying for benefits that they don’t need or they may never use. I am also constantly encountering situations where the investor owns an annuity that boasts a long list of benefits, and they rarely understand how these benefits actually work, or perhaps more importantly, how they do not work. When I speak with fellow advisors who recommend these products, I find that many of them struggle to understand the fine points of annuities themselves. In fact, I have experienced this so frequently that I would classify the problem as nothing short of an epidemic.
Advisors must spend a good amount of time reading the contract and/or communicating with the insurance company, to fully understand what their client has in their portfolio. Not doing this is in my opinion, dereliction of duty. Why is this so complicated, and what can be done about it? If advisors must make more of an effort to understand the fine print, so too must the insurance companies work to reduce the volume and complexity of that print. My biggest complaint with these annuity contracts is that there are so many variations of benefits that seem to be similar. For example, take the “lifetime income guarantee”, which seems to be pretty straight forward. You place a certain amount of money into an annuity, you invest the money for growth, then you “turn on the income” at some point in the future, and it pays you until you, or you and your spouse, die. So simple, right? So obviously beneficial.
But hang on – each company calls this benefit something different. Each company has a different age requirement, whereby you can turn on the “income for life benefit”. Also, each company may have certain hurdles for you to jump over, before triggering a lifetime income benefit, like waiting until you are age 62 or 65 to start income, or waiting for anywhere from 1 to 10 years after you purchase the annuity, or if it’s a joint annuity, waiting for the youngest person to turn age 65. What happens if you take income too early? That’s right, you just might lose the lifetime income benefit. Some perceived joint life benefits will be called a “spousal continuation,” which requires a reset or a step-up of the guaranteed value, for the surviving spouse to get the same income as the deceased spouse was getting. Otherwise, the surviving spouse gets the remaining investment amount left in the contract, which is NOT the same as the guaranteed benefit base. Get the picture? It is extremely convoluted.
I recently ran into a situation exactly like this, where the former advisor told the client that he and his wife would have an income for life, and that they didn’t need to worry about anything. Unfortunately, I had to deliver the bad news that this was not the case, and that this annuity product had a spousal continuation and not a joint life income benefit. Because the contract value was so far below the protected benefit base, there was no chance of the client getting a step-up, which would be required for the surviving spouse to retain the same level of lifetime income. Instead, the client will get whatever money is remaining in the contract. Well, that to me doesn’t sound like a spousal continuation. That sounds like she is nothing but a beneficiary. And these are the details, the fine print points and the insurance company smoke and mirrors that cause people (and their financial advisors!) such consternation.
Definition of contract value vs. benefit base: An annuity with a lifetime guaranteed withdrawal benefit, will have two main values to consider. The benefit base is a phantom account value is the “protected value” or the “guaranteed value.” This is the value that your lifetime income benefit is calculated from. This is NOT the value of your money, which is the “contract value.” The contract value is the amount of money you have left in the contract, and is the value that you would get if you walk away from the annuity.
Something else to watch out for: beware of excess withdrawals from annuities with lifetime income guarantees, that are calculated on a “pro-rata” basis vs. a dollar-for-dollar basis. This means that if you make a withdrawal from the annuity, that is greater than the annual guaranteed withdrawal amount, your future guaranteed withdrawal will be reduced by the same percentage of the excess withdrawal vs. the contract value. For example, you are collecting an income of $10,000 guaranteed amount annually from an annuity with a $200,000 protected benefit base. That’s 5% of the $200,000, which is fairly common. Remember, this is a withdrawal benefit, so your contract value is constantly being reduced by the annual income and is now down to $100,000. You withdraw an extra $10,000 from the annuity, which represents 10% of the contract value, so your protected base of $200,000 will be reduced by 10%, to $180,000. Your new annual income will now be $9000 per year. If your contract value was down to $50,000, then your income would have dropped to $8000 per year simply. This subtle timing difference can make a dramatic change in the outcome. The point here is that you and your advisor need to understand how these things work, because the wrong move on annuity can really impact your outcome.
So let’s be clear – the concept of the annuity, and many of these products themselves, are perfectly viable and valuable for certain clients. But the fact is that countering this potential positivity is a dangerous disease born of apathy on the part of financial advisors who are not doing their proper due diligence (or their jobs, really), and those insurance companies who create ridiculous levels of complexity in lieu of keeping things simple for investors, as they should be. This disease has become an epidemic and needs to be attacked head on by responsible financial advisors and regulatory bodies who should have the best interests of investors in mind at all times.
If you are an advisor who is recommending these investment products or a client who is contemplating a purchase of one of the products, then make sure you are fully educated on how they work and what you are obligated to do to ensure compliance with the contract. If you are the client, ask your advisor to explain the fine print. And if you are an insurance company, well, I’m not going to waste any ink asking you to change – but rest assured that financial advisors talk amongst themselves and publicly in forums like this. Be prepared for the consequences of making our lives, and those of our clients, more difficult.
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Ryan Wibberley is the Chief Executive Officer at CIC Wealth. Circle him on Google+.
