When the Dow Jones Industrial Average suffered a near-record collapse in 2008 401(k) plans went down with it. The drop led some to consider the volatility of the market and look for safer methods of savings. One option is to purchase annuities through insurance companies. Long considered good as gold, these investment vehicles provide continuous payment to retirees until the time of death. But our panel of financial analysts heeds caution when it comes to annuities. They say investors must consider their options and research the insurance companies before making a purchase, a good way to avoid placing a bet on a company that could become the next AIG .
In a way, deferred annuities are similar to consumption smoothing. They allow you to receive today’s money in the future, plus accumulated interest. A 60-year-old woman who is unsure how long she’ll live–like most of us–can use a deferred annuity to take money from a world in which she dies at age 75 and give it to her 92-year-old self.
But the contracts involved often restrict a buyer’s future use. If you die young, your money is pooled and used to pay current installments of other buyers. So the risk lies in your lifespan. The longer you live, the better a gamble such annuities become.
“You lose if you die young, and you win if you live a long time,” says Tom Davidoff, assistant professor at the Haas School of Business at the University of California Berkeley. With most plans, your family is unable to recover the remaining payments once you die. If you wish to leave your children or spouses a pile of liquid money, annuities may not be the best option. “The richer you are, the more you’re interested in leaving money for your kids,” says Davidoff. “That doesn’t happen with annuities.”
Still, annuities are a common form of retirement package, so it’s important to understand which type is best for you. The problem is that annuities are often mismatched for costumer’s needs, says Gregory Wood, founder of Securities Litigation, LLC. He says there’s an incentive for brokers to sell annuities because unlike mutual funds, sellers receive the same sizable commission on each annuity sold.
So it’s important to understand all the details of the contract you enter before you buy. Fixed annuities guarantee that your money will accrue at a minimum interest rate. Variable annuities invested in securities have the potential to earn higher interest on your payments but unlike fixed annuities, you can lose money. Both charge substantial fees for purchases.
One perk that has drawn consumers to variable annuities–you can defer your tax payments until you receive benefits–may not be as beneficial as it sounds, warns Gerard Klingman, president of Klingman and Associates. He says that with capital gains and dividends being taxed at rates lower than 15% it makes sense to invest directly in the market instead of through the annuity vehicle.
Guarantees are important in what Ron Sloan, senior portfolio manager for Invesco-AIM, calls a safety-driven investor mentality. But although the predictability of some annuities is tempting, he warns that these guarantees are only as good as the company. “Every now and then, you see these guys punching pretty hard, these insurance companies. So there’s still a lot of doubt out there,” says Sloan.
Sometimes this doubt is warranted, as there have been instances where insurance companies went belly-up–Equity Funding Corporation and Executive Life Insurance Co. are two examples. So even though a company may offer a competitive price, it may not be the safest place. And what good is an insurance firm that can’t be depended upon?
“The average consumer didn’t give a great deal of thought to the safety of some of the really big insurers,” says Bernie McSherry, senior vice president of Cuttone & Co. “But it’s certainly out there now, and people should be aware of it.”
Consumers should check the credit rating, often through A.M. Best Company, of their potential insurance carrier. They can also check with the state insurance commissioner’s office to see if a company has ever defaulted on its payments and to review complaint data and enforcement action history. Moreover, investors should diversify their annuities. McSherry recommends spreading annuity purchases among at least three or four providers.
Forbes. If you were a senior citizen planning for retirement, or even a younger person than a senior citizen, what sort of interest would you have in purchasing fixed annuities to guarantee an income? Is that a viable strategy? Does that remain viable when you’re doing financial planning? Is that a popular one now?
Bernie McSherry. The guarantees are only as good as the companies that you’re investing with. There’s a huge amount of liability. The insurance companies are all under a great deal of pressure, because they’re having trouble meeting their obligations going forward. And I certainly would recommend that people spread some of that risk around. I certainly wouldn’t want to see anybody lock up all of their life savings with one insurance company, with one annuity provider.
Forbes. Would you recommend a couple of annuities? Do you think annuities are good plans provided you spread the risk?
McSherry. I think annuities are up to individuals to assess. But I certainly would spread it among three or four providers at minimum.
Gerard Klingman. The issue, too, with annuities is that it’s a general term. And there are a lot of categories within that, from variable annuities to fixed annuities that pay a fixed rate, to lifetime income payment annuities. And each have different advantages and disadvantages and may fit in different situations. The interesting thing is, you know, a lot people are looking toward the lifetime guaranteed income type of annuities now.
And they seem attractive because with the stock market being so volatile, the bond market being volatile, it seems attractive to go back to almost having a fixed retirement income like people used to get from companies in the old
days. But I agree with Bernie, it’s only as good as who’s guaranteeing it. So, if you’re going to take that, you have to really do due diligence in terms of who the company is and diversifying that risk, because it’s not really guaranteed.
Ronald Sloan. Yeah, and you’ll notice, actually, insurance companies have started to put that little disclaimer on the bottom of their ads in the paper recently, that guarantees are only as good as the insuring company itself, the quality, or something to that effect. You can find it online when you take a look at their ads.
Klingman. I do believe that state insurance commissioners and, at some point, even the federal government has some interest in making sure that insurance companies can meet their contractual guarantees. If they don’t, then there’s a real issue of whether or not the insurance industry will even exist if they can’t pay out payments or pay death claims or disability payments. But it still is only a guarantee from the insurance company.
McSherry. Is it just me, or does anybody else find it strange that the government hasn’t responded to the TARP applications? Most of the insurance companies put in applications for TARP funds months ago, and they’ve not heard back.
Forbes. Why do you think that is?
McSherry. I don’t know.
Klingman. I think that, and this is just speculation, I think that the government is hopeful that the existing programs they put in place will right the financial system to the point where they won’t have to get to the insurance companies. Because when you come right down to it, basically, the insurance companies are investing in all these assets that have declined so dramatically, whether it be mortgages or corporate bonds of commercial mortgages or commercial real estate. So, I think they’re hopeful that what they’ve already done will work so they won’t have to go to that next step.
McSherry. Yeah, there are limited funds available. They’re probably saving them for the banks.
Forbes. Have any insurance companies defaulted, that you’re aware of, on their annuity payments or anything like that?
Sloan. I’m not personally aware of any specific ones. But, you know, every now and then you just open up your screen and you take a look and you see, you know, you see these guys punching pretty hard, these insurance companies. So, there’s still a lot of doubt out there.
Klingman. Yeah, the equity of a lot of these publicly traded insurance companies have dropped dramatically. I mean, they’re still all making their contractual payments, whether it’s life insurance or disability payments or annuity payments. Historically, there’s been a limited number of insurance companies that, you know, have had significant problems.
I remember Mutual Benefit in the late ’80s, early ’90s; also, Executive Life in New York around the time of the whole junk bond crisis in the ’90s. But in almost all cases that I’m aware of the state insurance commissioners have gotten involved and have had another healthy company ultimately take them over or put them in receivership so that benefits were still paid.
Forbes. And, you know, we were talking about different kinds of annuities before, Gerry. You had talked about how there’s fixed annuities, there’s variable annuities. In the financial press variable annuities have gotten a lot of bad press. What’s your opinion on that as a product? Are they still being sold at the clip they once had been? Is something that’s variable not all that attractive at this point to people?
Klingman. Our firm in general has believed for many years that the tax-deferral aspect of variable annuities, in general, does not overcome the higher expense and cost related to owning variable annuities. And the way the tax structure’s been the last couple of years, with capital gains and dividend rates being 15% or lower, generally buying stocks through a variable annuity ends up converting what would have been lower dividends in capital gain income tax rates to ordinary income tax rates.
So, in general, we have not been a proponent of variable annuities. Having said that, there’s some internal guarantees that some of them have. If we go into a higher tax rate on dividends and capital gains, it might make sense for some individual investors.
Sloan. I think one of the threads going through this conversation is just this whole idea of the mentality of investors right now. And that is security and safety and predictability is the driving force behind everything in today’s world.
Forbes. Yeah. And what I mean really picking up, especially with something like an annuity is, if you want them, definitely don’t put all your eggs in one basket.
Sloan. Yeah, like anything else.
Klingman. I think you always have to look at the carrier, the credit rating of the carrier has always been something that’s been important. I think it’s just obviously become even more important with the current financial crisis.
McSherry. Yeah, I think the average consumer didn’t give a great deal of thought to the safety of some of the really big insurers. It was never really an issue prior to this cycle. But it’s certainly out there now, and people should be aware of it.
Forbes. Yeah, because people bought a lot of insurance, in not just annuities, but insurance in general, almost like a commodity. There are a lot of online insurance comparison sites where you can find the cheapest provider and thing like that. But it doesn’t necessarily mean they are the best providers.
McSherry. Right. And we’re seeing some very highly rated insurer or formerly highly rated insurers now being downgraded pretty significantly.
Klingman. At the same time, there are a number of insurance companies, even, you know, mutual life insurance companies that have done reasonably well in a very difficult environment. So there are insurance companies that are weathering the storm.