The Top 50 Annuities
This article appears at the following website: barrons.com
Insurance companies have a long history of conjuring up new types of annuities to suit changing market conditions, and once again they've proved to be the masters of reinvention. Their latest brainchild: the deferred-income annuity, which has seen explosive growth since it was introduced three years ago, thanks mainly to its simplicity. You put money into the annuity, and then, two to 40 years later, you can activate a stream of income that is guaranteed to last a lifetime -- even if you live to 100 or beyond.
"It's like getting an old-fashioned pension, but it's not with GM or UPS. You build it yourself," says Sheldon F. Schiff, an insurance advisor to wealthy individuals at Bartmon, Shapiro & Associates in New York. "The great thing is that when you put money in, you know exactly how much you will get at age 65, 70, 80, or whenever you turn on your income."
Deferred-income annuities let investors plant a sapling now, then return to enjoy its fuller bloom later in life.
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Since New York Life introduced a deferred-income annuity in 2011, at least eight other insurers have jumped in with similar products, causing sales to more than double last year to $2.2 billion. That's a tiny fraction of the total $220 billion annuity industry, but a mighty spark when you consider that sales of its bread-and-butter product -- the variable annuity -- have slumped two years in a row and are 20% below their 2007 high.
Broadly speaking, the trend in annuities has been toward simpler products since interest rates have remained stubbornly low in recent years. Insurers invest underlying assets in fixed-income investments, so lower rates have made it more challenging to maintain capital reserves to cover annuity guarantees. The simpler the product, the easier it is to manage from a risk standpoint.
To help spotlight the best options in the changing landscape, Barron's narrowed the vast universe of annuity products to 50 of the most competitive contracts, and used basic assumptions, such as an investor's age and the size of the investment. The top-50 list is divided by annuity type, and includes only contracts offered by insurance companies with a rating of A- or higher from A.M. Best, which assesses insurers' financial soundness.
Overall, rates, fees, and payouts have improved over last year's levels for both fixed and variable annuities. Fixed annuities are principal-protected contracts with underlying fixed-rate investments. They can be structured as income annuities or to accumulate assets like a certificate of deposit.
Last year, the top rate on a fixed annuity with a five-year guaranteed rate was 2.3%; it's now 3.05%. For a 55-year-old man who puts in $200,000 for income beginning at age 65, the top four fixed-index annuity contracts with income riders last year promised to pay $19,522 to $20,649 in 10 years' time; this year, the offered range is $20,081 to $21,639.
In a variable annuity, assets are invested in underlying mutual fund-like investment options and grow tax-deferred, like an IRA or a 401(k). Gains -- or losses -- depend on market performance.
The variable annuities that made the top-50 cut have the lowest fees in the industry and no surrender charges, meaning you aren't penalized by the insurance company if you take your money out early.
New competitive contracts from Lincoln Financial and Guardian Life have helped reduce the range of fees on our list of contracts: The most expensive contract on Barron's list last year was Jackson National's Elite Access Variable Annuity, with a 1% fee. This year, the most expensive was Guardian Life's ProStrategies, which charges 0.60%.
Interestingly, the type of annuity with the highest sales in the industry for more than a decade -- a variable annuity with guaranteed benefits -- isn't on our roster of top contracts.
This type of variable annuity, which accounts for about 80% of the whole category's $142 billion in sales last year, can guarantee future income, liquidity, and a return of some assets to heirs.
The reason for the omission? Expense and complexity. The average annual contract cost for all variable annuities is 1.5%, including administrative fees and the cost of the insurance portion of the contract, or the mortality and expense fee. When you layer on the cost of the popular living benefits, as they're known, the average fee rises to 2.5%, and that doesn't include the management fees of the underlying investments, which can push total fees well above 3.5%.
Beyond the expense, investors have good reason to be wary of living benefits. After the market collapsed in 2008 and interest rates plummeted, many insurers found that they couldn't continue to back the rich guarantees. So they jacked up fees and shaved benefits on new contracts to try to regain fiscal footing, and some placed restrictions on how existing contract holders could invest to try to reduce the costs of managing the risk associated with the guaranteed benefits. Some insurers, such as AXA Equitable, Transamerica, and The Hartford, have offered to buy back contracts from customers.
We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!
But in its simple low-cost form without living benefits, variable annuities can be a good way for folks to invest more on a tax-deferred basis, after they've maxed out the contributions they can make to their 401(k), IRA, or other options. When fees are low enough, they don't wipe out the benefit of the tax deferral.
Investors seem to be catching on to the benefits of these low-cost variable annuities. While overall annuity sales were down in 2013, simple variable annuities drew substantial new assets. For example, sales of the top variable-annuity contract on our list, Jefferson National's Monument Advisor, which charges just $240 a year -- that's 0.12% on a $200,000 investment -- were up 77%, to $727 million last year.
The fixed annuities on our top-50 list feature contracts with the highest guaranteed lifelong income or the highest interest rates.
While interest rates remain historically low, with the 10-year Treasury at 2.6%, rates picked up gradually last year from 1.6% to 3% by year end, and investors took note: Sales of fixed annuities surged 18% last year, even as the stock market rose 30%. Sales of fixed annuities historically have been inversely related to stock market performance.
The biggest seller in this category is the fixed-index annuity, which guarantees a set rate return on the downside and a market-linked return on the upside. While underlying assets are invested in fixed securities, insurers buy options on the index that the contract is pegged to, typically the Standard & Poor's 500. If the options do well, investors get some of the index's upside, up to a cap, which these days is about 4%.
Barron's list includes only fixed-index annuities with income riders, which guarantee future lifelong income, because they are more easily sized up by investors. "You can look at the guaranteed income and know what you're getting," says Hersh Stern, founder of ImmediateAnnuities.com, a source of data on fixed annuities.
In contrast, with plain-vanilla fixed-index annuities, it's hard for investors -- and even advisors -- to know what they're getting, because there are so many moving parts. For example, there are varying bonus rates, surrender periods, payout rates, and cap rates. Dizzy yet? Well, even if you understand all of the parts, insurers have the right to change certain terms, typically every year.
Advisors caution investors to review fixed-income annuities with an seasoned expert, and to compare them with the new deferred-income annuities, which might pay out as much or more in a much simpler format.
The deferred-income contract is a variation on the plain immediate annuity, which converts a lump sum to income that begins right away.
When these annuities were first introduced, they were billed as longevity insurance and targeted to 60-something investors who wanted to turn on a income stream at a later age -- say, 80 -- to remove the risk of ever outliving the invested assets.
But insurers quickly learned that these products also appeal to a younger investor. Last year, New York Life lowered its minimum investment from $10,000 to $5,000, and tweaked the product line to enable flexible premiums, meaning you can contribute assets occasionally to your annuity, rather than putting up a lump sum.
"We wanted to make this something you could open like a new IRA and make recurring contributions," says Matt Grove, a senior managing director at New York Life.
Academics and economists tout income annuities as unbeatable by a simple laddered bond portfolio. (Of course, with the laddered bonds, the investor keeps the principal invested; with the annuity, he surrenders that principal when the income begins.)
Michael Edesess, an economist and partner at Denver-based Fair Advisors, found in a 2012 study that income annuities can be especially advantageous during periods of rising interest rates. Using 2012 rates, he compared how long income would last if a 65-year-old man put $100,000 in a 30-year bond versus an income annuity. If interest rates stay the same, the bond income would continue for 30 years. If rates rise by two percentage points -- which still would be a 40-year low prior to 2008 -- the bond income would dry up after 21 years. That's because as rates go up, the value of the bond goes down and investors must sell more to generate the same income.
The longer an investor defers taking payments from an income annuity, the higher the payments will be, because insurers have a longer period in which to invest the assets. "For a 50-year-old looking at one of these, insurance companies calculate the benefit using an internal rate of return of 4.5% or higher," says Debi Dieterich, senior annuity analyst at AnnuityAdvantage.com, a resource for information on fixed annuity contracts.
But it's the certainty of income that is the biggest attraction. It can help prevent having to take withdrawals from your portfolio during market downturns, and makes it easier to deal with the biggest challenge to retirement planning: You have no idea how long you're going to need to make your assets last, says Matt McGrath, a financial planner at Evensky & Katz.
The life expectancies of a 65-year-old husband and wife are 85 and 88, respectively, according to the Society of Actuaries. But what if one lived until, say, 95? There is only an 18% chance of that happening, but should the couple plan their withdrawals from their investment plan around this possibility?
If they don't, they're risking a late-life crisis. If they do, they have to take smaller withdrawals to make their assets last, and sacrifice their desired retirement lifestyle, says Wade Pfau, an economist and professor in the Ph.D. financial-planning and retirement-income program at the American College, an accredited school in Bryn Mawr, Pa.
David Litell, director of the retirement-income program, says that he knows first-hand how an income annuity can bring peace of mind.
"My father is 102. When he turned 84, he started to worry that he was going to run out of money and he would eventually get kicked out of his retirement community," Litell says, adding that his father's advisor wanted to take his money out of stocks and put it in a bond portfolio. "Instead, he bought an income annuity specifically to pay the retirement-home bill. He transformed from not sleeping well to not having a worry," he says.
Advisors caution that most investors should never consider putting all -- or even a majority -- of their assets into an income annuity. Assets contributed to an income annuity are highly illiquid, and if you die after payments have begun, the remainder of what you've invested stays in the insurance company's coffers.
"Insurance companies are transferring wealth from those who die early to those who live longer, that's how we can pay everyone more," New York Life's Grove says. "That whole thing relies on people not being able to tap their wealth."
While insurers have built some flexibility into contracts, the more flexibility you opt for, the lower your guaranteed income will be.
Of course, there's the risk that an insurer could go belly up, though there is a safety net: Each state maintains guaranty funds to cover insurance assets. For peace of mind, it's important to choose a highly rated insurer. And take comfort, since 2007, over 400 banks have gone under, compared to just 14 insurance companies.
The best way to use income annuities is in combination with a diversified investment portfolio. "A general rule of thumb would be if you're 10 or more years from retirement, you put 10% in an income annuity…and if you're starting retirement, one-third," says Greg Olsen, a partner at the financial-advisory firm Lenox Advisors in New York City. But the best answer, he adds, will depend on the size of your nest egg, what you want to leave to your heirs, your health, and your family's longevity history.
With the assured income from an annuity, "you may be able to take more risk with your investment portfolio to achieve a better rate of return," McGrath says. Or the risk-averse might take a little risk off the table and so toss and turn a little less at night.