By Scott Burns
Q. I have read the prospectus, spoken with friends and chatted it up with the broker. I cannot find what I am missing in a "too Good to Be True” annuity. Can you help me please?
I have $200,000 to put down on a “flexible premium deferred variable annuity." They say that if I give them $200,000, when I retire in 5 years (age 66) my initial investment of $200,000 will be $300,000 due to a 10 percent increase each year-end ($20,000 per year). I am guaranteed 5.25 percent interest on my $300,000 for life.
I asked for all the bells and whistles because I want the income for life, a death benefit for my heirs, etc. Where do the fees, sales charges, mutual fund expenses and 12b1(s) come from? Who pays that? If it is a variable annuity," how can I be guaranteed 5.25 percent per year for life? What if the value of my policy tanks with the market?
How do I ask questions, what am I missing? ---B.D., by email
A. Don’t feel badly, these are very complex products. Many of the people who sell them have only a limited understanding of how they work.
Let’s start with the very basics. If you examine the projection sheet you were given, that guaranteed $300,000 isn’t real money. It is how they promise to value your account for disbursement purposes. You will get 5.25 percent a year of $300,000, or $15,750 a year, guaranteed for life. The actual cash payment, however, will be coming out of the true cash value of the variable annuity account, a sum that is in another column. The value of that figure will depend on the market performance of the underlying investments, which are usually invested as a balanced fund, a combination of stocks and bonds. All fees come out of the actual value of your investment funds. Nothing is provided by the Tooth Fairy.
During the next 5 years the insurance company will be taking fees and expenses from the cash value of your investment account. These fees and expenses typically run a bit over 3 percent in this kind of insurance product with a living benefits clause. This is a very large burden for your investment to carry. It is greater than the 1.99 percent yield of the S&P 500. And it is greater than the yield on all but the longest maturity Treasury obligations. Basically, the insurance company will be taking every dime of dividend and interest income your money is earning, and then some. If your account is to grow, it will have to be by capital appreciation.
As a result, if your account has actually increased to $300,000 over the next 5 years you will be withdrawing at a rate of 8.25 percent when you start to take the guaranteed income (5.25 percent for you plus 3 percent in fees to the insurance company.) This will work to dramatically reduce the cash value of your account over time.
If the account does not appreciate, after expenses, to $300,000 in five years, your actual withdrawal rate will be still higher, drawing down your account value at an even faster rate. Suppose, for instance, that fees absorb all income and there is no appreciation so the account has an actual cash value of $200,000 in five years. Then your actual withdrawal rate will be 3 percent in fees plus another $15,750 a year, or 7.9 percent, bringing the total burden on your investment to 10.9 percent a year. With that great a burden it is highly unlikely that the principal value of your account will grow. As a practical matter, it is likely to decline. Worse, the annual withdrawals will reduce your death benefit so the value you may leave to your heirs will be steadily reduced.
Finally, let’s ask a rude question: How long will it take for you to get your original investment back, without interest and without any adjustment for inflation?
Answer: 24 years. (You don’t have access to the money for 5 years, and then you will need an additional 19 years to recoup your original investment. The life expectancy of a 66 year old man--- the age at which you are likely to be starting to take the income payout--- in America is currently 16.3 years. That’s 2.7 years less than it will take to get your money back.
This is a good deal for the salesperson and the insurance company he represents. It is unlikely to be a good deal for you.
Note to Readers: 9/21/11
I made exactly the kind of error I was warning readers about. I did a calculation using the wrong column in an insurance illustration. The result made the product look worse than it actually is because it made it appear that it would take 24 years to get your original investment back when it would really be 17.7 years.
Instead of having a less than 50 percent chance of getting your money back before dying, the correct figure means you have a better than 50 percent chance of getting your money back before dying.
Does that mean readers who have a living-benefits insurance salesman inviting them to a free dinner should immediately buy one of these policies?
Sadly, no. While “payback period” is a common method for evaluating business investments, it doesn’t consider the purchasing power of the money you receive during the payback period. And when we are thinking about retirement income, one of the key concerns is what our money will actually buy.
A better way to do the analysis, particularly for the relatively long periods of time considered with insurance products, is to evaluate the same promises of cash payments discounted for inflation. When you do that for the variable annuity with living benefits discussed in the column and set the discount rate at the current trailing inflation rate of about 3.5 percent, you learn that it will take 25 years to get your original purchasing power back.
That’s a long time.
I don’t want to get really morbid about it, but the life expectancy tables from the National Vital Statistics Reports tell us that a 65 year old American has only a 25 percent chance of living that long. For a typical couple in their sixties, 25 years is a reasonable figure for their joint life expectancy, the period of time that the last survivor spouse may expect to live. That’s why these particular products are good for insurance companies and their sales force. But for you and me, well, not so much.
