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Financial Life Advisor
An Insider’s Perspective of the Investment Marketplace Part 2 – Insurance Investment Products
When most people think of insurance, they think of the “what ifs”. What if I die, or what if my house is destroyed? Insurance for the “what ifs” is not investment, but rather risk management. After all, purchasing auto coverage will not make you rich but could protect you from becoming poor. Nonetheless insurance companies do provide investments. These investments are offered inside of “what if” insurance products like life insurance (for dying too young) or annuities (for living too long).
Life insurance maybe sold as an investment, but generally, I only recommend it as life insurance. That is completely shocking to some but common sense to others. Many of the investment features in life insurance contracts are similar to annuities, but for this discussion, I am going to keep this to just annuities. The tax ramifications and considerations in using life insurance as an investment are much more complicated than for annuities and would be confusing in the context of discussing investments.
Types of Annuities
Annuities are the most common insurance investment vehicle. An annuity’s concept is that a group pools their assets together through an insurance company that gives lifetime payouts to that pool. If someone lives longer than their life expectancy, they receive more benefits. If their life ends before their life expectancy, they receive less. This is how a traditional pension system works.
Of course, it is not that simple. Annuities come in many flavors and types. Most annuities sold are deferred annuities. A deferred annuity policy holds money and invests it for a future annuitization. At annuitization, the balance of the annuity is traded for a specified payout (e.g. lifetime, joint survivor, 10 years, etc). Annuitization is generally not required for deferred annuities, and actually is rarely done. Some statistics show as few as 1-3% of annuities are annuitized.
The type of investments which power a deferred annuity can also vary. There are two major types of annuities, fixed and variable. A fixed annuity invests in the portfolio of the issuing insurer, who guarantees a minimum interest rate. The insurance company must credit a minimum interest rate regardless of their own investment portfolio returns. Because of this obligation and State regulation, insurance companies generally invest in very conservative investments to besure they can pay the guaranteed interest rates.
Variable annuities invest in sub-accounts which do not have guaranteed returns. These sub-accounts are very similar to mutual funds. Mutual funds companies often manage the investments like the major mutual funds available outside the annuity. Variable annuities put the investment risk on the policy owner. If the sub-accounts decline in value, the annuity value decreases.
One a type of fixed annuity is an equity indexed annuity (EIA). An EIA takes most of the investment pool and places it in safe bonds (usually in the neighborhood of 90%). The remainder goes to purchase call options on a major equity index (most common is the S&P 500). If the index increases in value then the options are worth money and additional interest can be credited to policyholders. If the index declines, the option expires worthless and the bond interest has replaced the investment in the call options. These annuities have the guarantee that they will not lose money.
One major disadvantage of a call option is that it is the right to purchase an investment at a future date at a specified price. The actual investment is not owned, it is just the right to purchase the investment for a specific price. If the investment pays a dividend, only the owners of the investment receive the dividend. The option holder does not receive anything. Historically, dividends have accounted for almost one-third of stock market returns. EIA’s do not get the benefits of these dividends.
Fixed: Guaranteed interest every year.
Equity-Indexed: No chance of loss, but limited upside from equity markets.
Variable: Possible gains and declines in value from the stock market.
Taxation of Annuities
Annuities have special taxation rules. Before the age of the 401(k) and IRAs, the annuity was the primary retirement vehicle available to individuals. There are many similarities between retirement accounts and annuity tax treatment. Contributions to a non-qualified annuity are not tax deductible like a 401(k) or IRAs, but the growth inside them is tax deferred like those accounts. Also, like a them, annuities have a 10% tax penalty for withdrawal of gains prior to age 59 ½ and those gains are then taxed at ordinary income tax rates when withdrawn.
When investments are bought or sold inside an annuity, there is no tax consequence to that transaction. The annuity acts as a “tax blanket” while the investment is inside the annuity. This can be beneficial over time because taxes can have a significant impact on investment returns. Dividends and bond coupons are taxed when received outside of an annuity, but inside the annuity, they can be reinvested and grow free of current tax.
The major downside is that all investment gains are taxed at ordinary income tax rates when distributed from the annuity. Outside of the annuity, the qualified dividends and long-term capital gains are currently taxed at a lower rate. When taking a partial withdrawal, the gains must be removed before the original contributions. So, for instance, if $10,000 was contributed to an annuity and it had grown to $20,000 and $10,000 was distributed, all $10,000 would be treated as a distribution and taxed at ordinary income tax rates. For younger investors, the 10% tax penalty for early withdrawals prior to age 59 ½ makes taking early distributions less desirable.
When an annuity is annuitized into payments, the policy basis is returned pro-rata in each payment. Each payment will contain some gains (if any exist) and a return of principal. This continues until the basis is completely returned through scheduled payments. If the annuitant lives long enough, the payments can become entirely taxable income, once life expectancy has been eclipsed.
Unlike a taxable account which gets a step-up in basis, inherited annuities will still require ordinary income tax on the gains of the policy. Although annuities can be beneficial for deferring taxation over many years, there are several major considerations where an annuity can be less tax favorable than a simple brokerage account.
Annuities should not be used as a short-term investment vehicle. They are best suited to be used as a retirement savings vehicle when a 401(k) or IRA is not sufficient or available. They can be particularly unsuitable to young investors who may need access to the funds in the annuity before retirement.
Special Features of Annuities
Annuitization is probably the biggest advantage of annuities. A classic problem of planning retirement is how long retirement savings will have to last. With an annuity, payments can continue for life. This almost always provides the highest monthly income possible with the lowest risk. The part of annuity which really turns people off is that when they pass away, there is no asset left over for their heirs.
When selecting an annuitization benefit, more than one lifetime can be selected for the payout period. A couple can extend payments over the joint lifetime of the couple. Also, a period certain can be added to a lifetime annuitization. With a 10 year period, certain the payments are guaranteed to last at least 10 years from annuitization, even if the annuitant dies. A beneficiary is elected to receive those payments if the annuitant dies in the first 10 years. One of the most important features to consider with annuitization is inflation protection. With inflation protection, the annuity payments increase with the rate of inflation. This ensures not only that payments continue through life but also that they will keep up with cost of living increases.
Variable annuities developed new and innovative features and riders during the 1990’s and 2000’s. They promised investing in the stock market (inside of the annuity) yet provided guaranteed returns backed by the insurer. Each rider’s specifics can vary greatly from company to company and product to product. With the additional fees of the rider, the insurance company can engage in sophisticated hedging strategies using options. They usually require significant holding periods of 5 years to life for these riders, and the investment options were often limited.
Historical computer models and existing strategies showed these riders were viable and would deliver the promised benefits. The financial strength of insurance companies put credence to the viability of these riders. In late 2008, these riders came under great stress. With the financial markets “dislocated” and credit markets drying up overnight, the historical computer models and strategies were broken. If deterioration had continued, it is questionable whether these annuities could have delivered on their promises. Since then, insurance companies have looked very closely at their policies and these special riders. Many companies have raised the cost of these riders significantly, eliminated them, or modified them to provide lower benefits.
In some states, annuities have legal protection from creditors. In these states, creditors may not be able to go after the value of the annuity when seeking a judgment or collection in bankruptcy. A regular brokerage account does not have this benefit.
Costs of Annuities
The largest complaint about annuities is their high cost structure. A variable annuity will typically have several types of underlying expenses. The most common types are M&E (mortality & expenses), administration and sub-account expenses. These combined expenses often exceed 2% a year. If riders are selected, especially a living-benefit, annual expenses can exceed 3%. Considering the typical mutual fund costs are 1-1.5%, an annuity looks very expensive.
One reason that expenses are so high is that annuities pay very high commission rates compared to other investments. Insurance companies will advance commissions to agents for selling annuities when mutual funds would pay a much smaller commission. Commissions may be as high as 25% paid to agents for the sale of fixed and EIA annuities. For variable annuities, commission rates may be as high as 10%. The insurance company advances those commissions because they know they will receive their money back over time.
Once in an annuity, the policyholder has limited control. Even in a variable annuity, where there could be hundreds of investment sub-accounts, the choice of sub-accounts is made by the insurance company. Insurance companies can change out sub-accounts as they see fit and change the fees and expenses for those sub-accounts.
In a fixed annuity, the insurance company declares an interest rate which is credited to policy holders. Countless policies pay up front bonuses and enticing initial interest rates, only to later have the rate decline significantly - even to the guaranteed minimum. In a fixed annuity typically no annual fees are charged, but the insurance company makes their “fee” on the spread (difference) between what they earn on their investment portfolio and the crediting rate of the policy. Insurance companies generally do not disclose the spread they earn on a policy.
Annuities almost always have surrender charges that are assessed if money is withdrawn from a policy within a certain number of years. Surrender charges can range from 5% to 20% and last for 7 to 15 years. Once the policy is purchased, the insurance company either earns their fees for many years to repay the large commission paid to the sales agent or they take a huge chunk of the investment to pay the commissions they have already paid out through a surrender charge.
Many agents point out the tax benefits of an annuity, but many annuities are sold inside of a retirement plan (IRA, 401(k), etc). Inside a retirement plan the annuity adds absolutely no additional tax benefit. The living benefit riders have become one of the most common reasons for recommending annuities for retirement accounts. In the wake of the 2008 financial crisis, the cost of living benefit riders have become even more expensive, and the promised benefits they provide are lower.
I have reviewed numerous variable insurance policies. Many policy prospectus and investment prospectus can run several hundred pages. In one particular case I remember, the contract provisions from a major insurer exceeded 100 pages and the investment information, 400 pages. Whenever something is that complicated, it is impossible for most individuals to understand it. Insurance companies write policies to make money. The more complicated policies are, generally the better they are for the insurer.
The other parts of this series:
Part 1 – How are Financial Products Distributed
Posted by Ben Gurwitz on 10th May, 2010 | Comments | Trackbacks
Tags: May 10, Investments
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