(express news) -- Fixed-rate annuities, fixed-index annuities, variable annuities — how do I hate thee? Let me count the ways.
I will address annuities’ mediocre returns and high fees in a future column. For now, let’s focus on their complexity.
Complexity matters because of a basic rule of financial products I just made up.
If you read it out loud, it sounds a lot like your Miranda rights: “You and your money have the right to simplicity. Whatever you can’t understand can and will be used against you by the financial service provider.”
Annuities come in three main flavors.
The vanilla flavor — fixed-rate annuities — is actually fairly simple. These are not evil. You give money to the insurance company, either all at once or over time, and it agrees to give you back your money in equal monthly payments, either for a fixed amount of time or, most often, for the rest of your life, guaranteed.
The only complex math going on in the background of fixed-rate annuities is an actuarial guess about when you’ll die.
The other two flavors — the confusingly named fixed-index annuity and its close cousin, the variable annuity — are far more complex.
Their structures vary from company to company, so in describing them, I can point out the complications, but the specifics will be hidden somewhere in the fine print of your contract. Like an Easter egg hunt, but with rotten eggs.
These flavors start out with opaque calculations as the insurance company collects your money over time. At some point — when you’re done giving your money to the insurer — they morph into a simpler fixed annuity. In this way, the fixed index and variable annuities are like hungry, fuzzy caterpillars, which are disgusting to look at.
But eventually, they become simpler fixed-rate annuity butterflies.
In prepping this review, I read every word of some of the most boring, variable-annuity product plan documents you can imagine — three company contracts from 2008, 2014 and 2018, plus The National Association of Insurance Commissioner’s Buyer’s Guide To Deferred Annuities.
So, about the complexity of fixed-index annuities and their variable-annuity cousins — both give the buyer exposure to “the market,” but in an indirect way.
With a fixed-index annuity, you give your money to an insurance company, and it promises to credit your account with some of the gains of a stock market index, such as the S&P 500 of large-cap companies or the Russell 2000 index of small-cap companies. But exactly how it does that is usually calculated in a complex way.
The insurance companies’ value proposition is that they say you can participate on the upside when the stock market appreciates, but they will provide some protection from loss when the stock market either drops below the amount you put in or below the previous year’s high-water mark. It’s the “some market upside and some safety” combo platter. Sometimes that’s protection against a 10% drop in the market, sometimes it’s against any loss of principle.
But how do they provide this “safety”? A bunch of ways.
Sometimes the contract limits your upside by a “participation amount” such as 80 percent of the index gains. So if the market index returns 10 percent, you get credit for just an 8 percent annual gain.
Another feature might be a “performance cap” that limits the amount an insurance company will need to credit you with in a bull market. The market went up 12 percent? Sorry, your gains are only 9 percent.
You might pay a “spread rate” — that’s a percentage of market gains by which your insurance company subtracts your returns. Spread rate doesn’t sound like a fee, but that’s what it is.
A particularly devious way to limit your returns is to only credit the price change of an index, but not the dividends you would have received if you owned the index in a brokerage account. As I’ll explain in a future column, that might mean you’ve left half your gains on the table.
How does the company handle all this complexity?
As Jefferson Bank’s contract clearly states: “Subsequent Accumulation Unit Values for each Sub-Account are determined by multiplying the Accumulation Unit Value for the immediately preceding Valuation Period by the Net Investment Factor for the Sub-Account for the current period.”
It goes on like this for a couple of pages. I’ve read all the words, and my head hurts.
Let’s go to the AXA Equitable document, to figure out our “Guaranteed Annual Withdrawal Amount.” Well, you see it’s, the, um …
1. “The sum of contributions that are periodically remitted to the PIB variable investment options, multiplied by the quarterly Guaranteed Withdrawal Rate (GWR) in effect when each contribution is received, plus
2. “The sum of (i) transfers from non-PIB investment options to the PIB variable investment options and (ii) contributions made in a lump sum, including but not limited to, amounts that apply to contract exchanges, direct transfers from other funding vehicles under the plan, and rollovers that are allocated to the variable investment options, multiplied by the Guaranteed Transfer Withdrawal Rate (GTWR) in effect at the time of the transfer or contribution, plus
3. “The sum of any Ratchet Increase.”
Got it?
OK, here’s what you do need to know. You can’t independently observe their math. You own rights to a complex derivative — that’s not what they call it, but that’s what it is — and only they can tell you what that derivative is worth.
With a regular brokerage account, by contrast, you would see an observable market price for a mutual fund or a stock or a bond.
Remember, anything you don’t understand can and will be used against you.
Do you want your money back yet? You can’t have it.
Generally, once you’ve annuitized, you can’t accelerate or change your fixed-rate annuity. Prior to annuitization, you can have some, but you will probably pay surrender or withdrawal charges on any fixed-index or variable annuity that you want to get out of. You may be able to get 10 percent of your money back each year without penalty, but for additional funds you should expect to pay a 5 percent fee under many contracts, with a slowly declining penalty amount per year.
So that’s the story on complexity and illiquidity. I’ll tell you next time about the bad returns and the high fees.
