Should Your Portfolio Include Annuities?

It is generally a lousy idea to buy an annuity as a retirement savings vehicle. However, the income from an annuity, specifically a variable annuity, can protect against the financial risk of a long life and offers some protection against inflation.

The first part of this article illustrates that annuities can provide income benefits to someone with limited resources and no strong desire to leave something for their heirs.

The second part illustrates three factors in the design of an immediate variable annuity:

• The term over which payment will be made
• The insurance charges and other expenses; and
• The benchmark rate or assumed investment return.

With an annuity, income taxes are deferred until money is withdrawn, much like taxes are deferred with a buy and hold stock portfolio. Fixed annuities perform much like bonds while variable annuities perform like stock mutual funds. Annuity income is taxed at rates which can be twice as high as the rates of tax paid by the stock fund investor.

The expense ratio of an annuity, to borrow the mutual fund jargon, is often at least one percent higher then the expenses of the underlying mutual fund (endnotes, ref. 1.)

Consequently, annuities are not an attractive way to save for retirement, compared to a buy and hold investment strategy, because of the higher tax rates and higher expenses.

However, once you retire and begin to draw upon your savings, annuities have an important advantage in that they provide protection against the risk of living a very long life. John is in his middle '60s with no one to whom he wants to leave an inheritance. He is likely to live for another fifteen or sixteen years but there is a 10% chance that John might live beyond age ninety.

His dilemma is that he must husband his retirement savings, make it last twenty five years or more, even though in all likelihood he could safely draw upon his savings more rapidly.

While it is difficult for an individual to define how long financial resources must last, an insurance company can determine, on average, how long people are likely to live. In conceptual terms, the insurance company agrees to pay John for as long as John lives but they allocate his premium dollars over a time period equal to his life expectancy. The insurance company can afford to do this, whereas John cannot, because for every annuitant who lives a long time another dies prematurely.

The net result can be more money each month to John, even after the extra fees and extra income taxes.

Let's look at this example in more detail. John, a California resident, could choose an equal allocation to stocks and bonds which might grow about 10 and 5.5% annually, net of expenses, when held in mutual fund accounts. The stock portfolio distributes 5% dividends and short term capital gains each year and this distribution, and the bond income, are taxed currently.

Tax is deferred on appreciation within the portfolio until the stocks are sold.

Alternatively, John could invest half his money in mutual funds and half in annuities with similar investment objectives. Investment returns would be about 1% smaller than with mutual funds because of insurance and other expenses and annuity distributions in excess of John's initial investment would be taxed at ordinary rates (ref. 2.).

John expects inflation to be about 4% but he wishes to maintain his standard of living until age 91. The shift of half of John's investments to annuities allows him extra spendable income, net of income taxes, as shown in the accompanying table.

There is no free lunch. If John were to die at age eighty, his heirs receive less money if John purchases an annuity. (The entries for future worth are pre-tax.) Thus it is important to confirm that there is no one to whom John wishes to leave an inheritance.

The turnover within the mutual fund influences the relative annuity performance. If the mutual fund distributes all income and appreciation annually then, as shown in the third column, John's spendable income decreases compared to that provided by the annuity. If he invests very tax efficiently, spendable income can be about the same as that provided by the annuity. The effects of variation in insurance changes and expenses are much smaller.

Endnotes

1. For comparative information, check your local library for a source like the Morningstar Variable Annuity/Life Performance Report. Or, use the Internet to check the INN- Morningstar variable annuity database.

2. A portion of each distribution is not taxed until the initial cost of the annuity has been recovered. The non taxable portion is called the "exclusion percentage," the cost of the annuity divided by the annuitant's life expectancy as listed in special actuarial tables. Check IRS Publication 939 for details.

At age 65, the IRS unisex life expectancy is 20.0 years. Click here for Pub. 939 Table V, One Life Expected Return Multiples.

A portion of each annuity payment is return of principal and is not taxed. The rest is ordinary income and is taxed at higher than capital gains rates. The untaxed portion is known as the exclusion amount and is calculated as described in IRS Pub. 939.

The investment return of a fixed annuity is guaranteed by the insurance company whereas the return of a variable annuity is determined by the performance of the underlying mutual fund or "subaccount." The annuitant shoulders the investment risk with a variable annuity, in return for the possibility that subaccount will grow faster than inflation, whereas fixed annuities involve no investment risk but provide no protection from inflation.

Both variable and fixed annuities can be for life or for a "period certain." Life annuities assume that payments will be made over the actuarial life expectancy, which is about nineteen years for the aged seventy female client in these examples, whereas period certain annuities assume payments over the time period specified in the contract.

Our focus is on simple annuities without any bells and whistles. Since the marketplace contains thousands of products blending all sorts of features, it would be foolhardy to purchase an annuity without professional advice. This discussion should provide you the knowledge to interact effectively with your insurance agent.

Each subsequent payment of a life annuity is the prior payment multiplied by a factor which is defined in the annuity contract. To a close mathematical approximation, the factor for annual payments is

factor = 1 + net change in subaccount - benchmark rate

If the subaccount increases by 8.25% before expenses, about the historical return for a balanced portfolio containing half stocks and half bonds, and if total expenses are 1.25%, the net annual change in the subaccount is 7% and the factor is 1.0300.

factor = 1.000 + ( 0.0825 - 0.0125 ) - 0.0400 = 1.0300

This algorithm continues indefinitely with no implied termination. A life annuity guarantees payment for life, no matter whether that life is short or long.

To illustrate the calculation of a life annuity, let us assume that the annuity were purchased through The Hartford, Providian Life or Vanguard. The initial monthly payments differ because of differences in the companies' actuarial tables (see differences in the implied term in the accompanying table) and differences in the benchmark rate.

The Hartford offers a variety of subaccounts; the "Hartford The Director Dividend and Growth" subaccount was selected for this example. The investment return, before expenses, was assumed to be 8.25% and costs were obtained from the INN/Morningstar annuity site.

Providian offers twenty three subaccounts but none are a blend of stocks and bonds. Therefore, you would need to purchase two contracts for $50,000 each and base one on stocks and the other on bonds. Investment returns of 10 and 6.5% were assumed so as to produce a composite return of 8.25% before expenses. Providian's costs are from the INN/Morningstar data base.

Vanguard offers nine subaccounts, one of which is a "balanced" portfolio. Costs were taken from Vanguard's April 30, 1998 prospectus.

These assumptions and expenses translate into increases of $ 9, $19 and $23 per month for the three contracts. Since investment returns were identical, the differences arise because the contracts have different expenses, mortality and expense (insurance) charges and benchmark rates.

The initial monthly payment is smaller because the payments are being spread over a longer time period, thirty years for the term certain annuity vs. about nineteen years for the life annuity.

This term certain annuity has a cash value, meaning that there will be money left for your heirs if you die before the end of the term and, with this product, cash can be withdrawn should a special need arise. (There may be surrender penalties upon withdrawal and withdrawals will decrease future payments.) A life annuity generally has no cash value, no possibility of special withdrawals and no residual value at death.

Calculating subsequent payments for a term certain policy is a matter of tracking the cash value year by year. This annual example is a mathematical approximation to the methodology defined in the annuity contract.

The insurance company sets aside enough money to fund the first year's payments and invests the balance, $95,069 in this example, in the subaccount. The set aside is slightly less than twelve payments because 4% interest is being credited to the payment account.

The value of the subaccount changes by 8.25%, or 6.34% after expenses, over the year. This translates into a net change of $6,027. The cash value at the end of the year is the invested value at the beginning of the year plus the net change in the subaccount.

The monthly payment in the second year is determined from an annuity calculation but, this time, the payment is based on the current cash value and the remaining term. The payment in the second year increases by $15 per month in this example.

The payment in the third year is calculated exactly as in the second year: money is set aside to fund the monthly payments and the balance in invested in the subaccount. The cash value at the end of the year changes by the net change in the subaccount and the third year's income is based on the cash value and the remaining term at the end of the second year.

If you calculate payments over a number of years, you will prove that the cash value goes to zero in the last year of the contract.

Let's examine the twentieth year. The monthly the payment has increased substantially even though the cash value has decreased. Income increases because the remaining term has decreased faster than the cash value.

Twenty years is about the median life expectancy of the client in this example. If the client were to die at her life expectancy, her heirs would be entitled to the cash value of about $82,000. If the client had purchased a life only policy, her heirs would receive nothing.

This then is the dilemma facing the client. They will probably live to about their actuarial life expectancy but they might live for thirty years. If they purchase an annuity for a fixed term, they must go long and a long annuity provides less income. If they purchase a life annuity, their income will be higher but there will be nothing for their heirs.

The subaccount investment has returned constant in these examples although it will fluctuate in any actual annuity. When the market has a down year, subsequent annuity payments will be adversely affected. The effect of market fluctuations will be examined subsequently.

With the life annuity, the client has transferred the risk of living a long time to the insurance company in exchange for giving up any cash value at death. The result is a substantially higher monthly income with the life annuity.

The income from both annuities increases at about the 3% per year trendlines. Thus, if inflation were about 3%, the monthly annuity payments would maintain a constant purchasing power. We shall see that the rate of increase of either annuity can be adjusted by changing the benchmark rate.

Suppose that the securities markets were to enter a prolonged slump with little long term gain. The next chart illustrates that annuity income would decrease 6% per year if the subaccounts were to lose 2% a year after expenses.

Expense differences affect your monthly income. The chart compares two annuities which differ by 1% in expenses. Both annuities are for life, provide a 7% (6%) net return and are based on a 4% benchmark rate.

Income from the "low" expense annuity increases on a 3% per year trend whereas the "high" expense annuity increases on a 2% per year trend. Other things being equal, the effect of extra expenses is to decrease the rate of growth of future annuity income by the amount of the extra expenses.

Ideally, annuity income should increase at the rate of inflation. Therefore, the slower rate of growth of the "expensive" annuity is probably not in the client's best interests.

One can affect the rate of income growth by changing the benchmark rate. This is illustrated by the next chart where the benchmark rate used in the design of the "expensive" annuity has been reduced from 4 to 3% with other factors unchanged.

Increasing the benchmark rate reduces the initial payment from $627 to $576 per month but causes future payments to increase at a 3% trendline. So, by selecting different benchmark returns, it is possible to design both annuities to protect purchasing power if inflation is a steady 3% per year.

The difference in annuity income corresponds to a difference of about $8,000 in the cost of a $100,000 annuity. That is, if you were to invest $108,000 in an annuity with higher expenses, you get about the same life payments as if you had invested $100,000 in an annuity with lower expenses. This $8,000 represents your cost for planning and other services provided by your broker and insurance carrier. If you pay your adviser directly, you should add their fees to the cost of the annuity that they recommend before comparing to an annuity where you advisory costs indirectly through increased expense charges.

The next chart illustrates the performance of a hypothetical variable annuity purchased forty years ago. The annuity was invested in a hypothetical subaccount of large US company stocks and intermediate term US Treasury securities. The resulting balanced portfolio gained about nine percent annually, before expenses, from 1958 through 1987 (the year of the October "crash.") Inflation averaged about 5% annually over this period.

Expenses and M & E charges totaled 1.25% annually. The benchmark rate was 2%. (Yields were running at about 3% in the late 1950s.)

The solid dots represent the monthly income from this hypothetical historical annuity. The annuity income does not follow a smooth trend as in the earlier examples because the market return is not constant. Income drops steeply in 1974 and 1975 and rises after about 1980. Welcome to what the real world might be!

The rationale for basing annuity income on the performance of the subaccounts is to provide a weapon to help your income withstand the ravages of inflation. Take a look at the change in the cost of living and decide whether the variable annuity kept income in pace with inflation.

This strategy was "successful" in that the increase in annuity income exceeded the change in the cost of living if measured as of the beginning and end of the historical period. However, inflation outpaced income gains over much of this period and annuity income declined, in real terms, by a factor of two in the late seventies.

You may remember that stock market went down in the 1970s. This decline coincided with an upsurge in inflation and the combination sharply reduced the purchasing power of the annuity income.

To paraphrase Mr. Churchill's comments about democracy, a variable annuity is not guaranteed to provide a secure financial future but it is a better strategy than the alternative of fixed annuity payments. Someone who chose a 2% fixed life annuity in 1958 saw their purchasing power decline four fold by the end of the period! Compare the solid and dashed lines in the chart.

Your state may assess a premium tax. For example, California assesses 2.35% of the value of the contract when it is annuitized. This tax is not deductible on your federal income tax return.

Check your motivation. Shifting the uncertainty about when you will die is a good reason to consider an annuity. Trying for a better return on your money is not a good reason to consider an annuity. There are better investment alternatives.

Investment professionals can obtain analytical software from the AEGON Financial Services Group, Inc. 800.797.9177. Software is also available from T. Rowe Price, Morningstar, DATAMAX and probably others. The author did not use these products in the analyses described herein.