How Inflation Impacts Annuities

HOW INFLATION IMPACTS ANNUITIES

Annuities, which is a very broad term, can provide protection from various forms of financial risk. The most common annuities we see these days are Variable Annuities with Living Benefit Riders, but there a few different types of annuities and several different forms and versions of the riders.

Big picture, an annuity in its simplest form is a fixed sum of money paid to someone for a set number of years, or for their lifetime. For example, if you were to retire at 65 and had saved up $1million, you could do many things with the money to provide an income stream, and giving all of your money to an insurance company and asking them to pay you $50,000 a year for the rest of your life would be one of those options. This is called a Single Premium Immediate Annuity, or SPIA for short, and this is an option that exists in the market.

By choosing the annuity, you've now transferred certain financial risks to the insurance company in exchange for other risks. The risk you transferred is pretty simple, if you were to keep the money and invest it yourself and those investments did poorly, you risk running out of money before you die. In exchange, you accept the risk that inflation will impact the buying power of your $50,000 income. There are other risks you exchange like longevity risk, interest rate risk, and reinvestment rate risk, and the insurance company has a mathematical formula for making sure the exchange of those risks are in their favor, but this letter is about inflation.

Inflation risk is greater than many people realize, especially when you're talking about 20 or 30 years out. Using the "Rule of 72" we can quickly assess that if inflation hovers around 5% for 14.4 years, you would have lost half your buying power. That means that at age 79, that $50,000 now spends like $25,000. While I understand market risk can be scary, because it's immediately reflected in your account balance, the slow and silent portfolio killer is actually inflation.

WHAT ABOUT VARIABLE ANNUITIES WITH GUARANTEED INCOME BENEFITS AND OTHER RIDERS

Do you like magic? I love magic, I saw Penn and Teller in Vegas once and I was captivated, the illusions can really play on different parts of the mind. As someone who has a passion for transforming how clients see their financial advisor and how they view their own personal finance story, I've realized there's a fine line between magic and sales. The illusion is performed because the performer can occupy the mind on one hand, while they pull off the "trick" with the other. It's really just deception, and I do have a lot of respect for those that are good at it, it's not easy to master.

The intersection between annuities and magic is simple, distraction. If you're familiar with annuities or have been sold one, consider the SPIA as I described it above, in it's simplest form is exactly what many of the annuities sold actually promise. You give the insurance company a lump sum of money, and they promise to return it to you in a series of equal payments for the rest of your life. Sure, there are annuities that have living benefit adjustments, doubles if you wait 10 years, annual benefit increases for waiting, guaranteed floors so you can't lose money, death benefit payouts, guaranteed return of premium, and a whole host of other "distractions" that can keep you from seeing what the contract with the annuity carrier actually is. It's a lump-sum payment for a straight line payout, but with certain stipulations.

To be clear, we're not annuity haters like some, we believe they can have a place for a small portion of an investors assets. Because our goal as advisors is to reduce all forms of risk by diversifying assets across different asset classes and tax classifications. Where we see many people get stuck is when they become over-invested in certain types of assets, especially annuities. They accept too much inflation risk with inadequate assets to offset that risk. This typically happens when "bad advisors," that only sell insurance products, are able to convince people their money is somehow safer inside the insurance company than it is anywhere else. This is something I have a massive problem with, and so does the Department of Labor. There are new rules to help prevent "bad advisors" from convincing investors to overinvest in products with high fees and/or high commissions. You may hear some grumblings about this rule, and it does require more work for the advisor, but I'm a huge fan and I hope it's enforced in a way that pushes many of the "bad advisors" and "bad practices" out of our industry.

In full disclosure, my first job out of college was on an annuities desk for John Hancock in Boston. At age 24, without the ability to really see the big picture and without the experience to understand investments and our industry, I did exactly what I'm now saying is misleading and unethical. I would distract advisors with all the "benefits" and they would take that information to clients and in many cases convince them to overinvest in the annuity. I'm not proud of it, but being that close to it allowed me to see how disturbingly deceptive the financial services industry can be. Once I gained the experience to see it, I vowed to do business differently and provide a better experience to my clients.

HOW HIGH ARE THE FEES?

To be clear, in many instances they're excessive. However, it's not the actual fee that bothers me as much as how it's presented and justified. Annuity fees come in many different shapes and sizes and before recent changes to the disclosure requirements, were seldom presented to clients properly. In a typical Variable Annuity with a Lifetime Income Rider, let's assume between the Mortality and Expense fee (M&E), rider fee, and investment fees, a client is paying 3.5% annually for the product.

In the same $1million example, that's $35,000 a year in fees. Let's assume they've "guaranteed" you $50,000 of income for the rest of your life, but you have to use their investment models. The models are likely more aggressive than you would be with your money if you didn't have that peace of mind knowing the $50,000 of income won't go away. The rider fee is typically locked against the "benefit base," or whatever fancy term they use for the fake amount they calculate the income off of. In total, $85,000 a year, an 8.5% withdrawal rate, which puts a pretty significant burden on those investment accounts to keep up, so the account balance eventually begins to decline.

At first slowly, but as the drag grows to 10% or 12% of the contract, the investment performance has no chance to keep up and the value declines more rapidly. The M&E fee is based on the account value, so that starts to decline, as does the investment fee, however, the 0.75% to 1.5% rider fee, in our example let's assume it's 1.25%, does not. It's still based on the $1million. So, if the account value declines to $500,000, the M&E and investment fees might total $12,500, while the rider fee remains $12,500, for a total of $25,000. The fee is now 5% of the account value, compared to many investment management fees between 1% and 1.5%, I believe that constitutes the very nature of the term "excessive."

Let's also consider for a moment how much you've paid thus far in total, if we're 14.4 years into the contract at this point, assuming the fees started at $35,000 and are now $25,000, and to make it simple an average of $30,000 over that time, you've now paid the insurance company $432,000 to essentially just hold onto your money and hand it back to you. When you stop and consider all those bells and whistles, all of those extra "features" of the annuity, what really happened was you handed an insurance company a lump sum of money and they've been handing it back to you. To this point, you've paid them $432,000 for that service, and they've given you $50,000 a year, which is starting to spend more like $25,000. You also have to keep in mind, not a single penny has come out of the insurance company's pocket, all of the money that's been given to you was yours.

Let's assume the balance of the account eventually reaches zero after the next 14.4 years, I'll spare you the long explanation, you've continued to receive the $50,000, which is spending more like $12,500 now, and you paid an additional $261,000 in fees during that time. At this point, the insurance company has collected $691,000 in fees from you. You're 93 years old and still in pretty good health, you live for another 5 years, and continue to collect that $50,000, but now you're in the pocket of the insurance company. Or are they simply giving you back $250,000 of the $691,000 they collected? In this scenario you paid $441,000 to the insurance company, you received $50,000 a year that slowly felt less relevant as inflation ate into the buying power, and you have no money to leave your children or grandchildren. What if you would have passed at 93? What does the life insurance company know about life expectancy that allows them to turn these annuity products into highly profitable contracts for their company?

SO WHEN ARE ANNUITIES APPROPRIATE?

When they're used to find alternative methods of reducing portfolio risk while maintaining a good asset class and tax class allocation. Annuities can provide benefits to portfolios, although anecdotally we find they're appropriate for fewer than half our clients. Annuities are not the devil, but they're also not designed to be sold as a one size fits all, shove all your money in there product either. Annuities are not a pension, however I even used that line when I tried to explain how they worked several years ago. Pensions are typically tied to a group of salaries within the company that administers the pension, so when inflation occurs and drives the salary range higher, the pension payouts increase. Annuities are not "wrappers" for your investment portfolio, but I've also used that line when trying to convince advisors to sell the product I represented. The reality is, so many of them have features that distract your eye/mind from what you're really getting. They're not the one-size-fits-all, shove all of your money in there and send thank you letters to the insurance company because of how wonderful they are, products many "bad advisors" claim they are. And I'm very excited about the new rules/laws that now force advisors to disclose the details of any investment recommendations they make when dealing with qualified accounts. I hope this also forces insurance companies to design the types of products that can be used to help offset portfolio risks as opposed to product designs meant to overwhelm people with all the features and generate exorbitant firm profits.

If you have any additional questions or comments about annuities, or other insurance products I didn't really cover, please send me a note. We got quite the response when I mentioned insurance products in a recent newsletter, and I wanted to more fully clarify my statement and my experience with annuities. We could also talk about permanent life insurance and other types of annuities if you're curious, both of which we feel have a place for certain clients and situations, but often get sold as the "foundation" of a "financial plan."

Please share this with anyone you feel would be interested, and be on the lookout for the Sphere Weekly on Wednesday or Thursdays.

Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a federally registered investment adviser. PCIA: 6201 College Blvd., Suite 150, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”) and Prime Capital Wealth Management (“PCWM”).

The preceding commentary is (1) the opinion of John Paul and not necessarily the opinion of PCIA, (2) is for educational and informational purposes only, and (3) should not be construed or acted upon as individualized investment advice or as a recommendation to buy or sell any investment. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Past performance is no guarantee of future results. Commentary is for illustrative purposes only. Interest rates may vary and your specific situation could be different.