The sale of annuities is on an upward march. Insured Retirement Institute (IRI) calculates that industry-wide, annuity sales increased 4.2 percent to $220.9 billion in 2013, up from $212 billion during the previous year.
The real driver seems to be the want, or the need for income. IRI President and CEO, Cathy Weatherford states:
“It’s particularly noteworthy that income annuities continue to break new barriers, passing the $3 billion mark for the first time and reaching $3.5 billion. The growing popularity of these products shows the expanding market of consumers looking for certainty through guaranteed lifetime income. As the baby boomers continue to retire, we expect this demand to remain strong.”
Part of this is driven by fear of an impending crash and the desire to lock in some guarantees. Others see the market cruising upward and anticipate a smash hit due to the dramatic increase throughout the past several years.
Alternatives to Annuities
The problems with annuities are the high fees and the lockup periods. As such, they may not be for everyone. For those wanting some similar attributes without the fees and lockup period, there are alternatives.
At its heart, insurance companies purchase a pool of investments along with options and future contracts in order to provide returns similar to the stock market. In recent years, the participation rates have gotten a little more difficult to follow with certain caps.
Some clients want the benefit of an annuity, but don’t want an insurance-based product. They want guarantees, but need growth to accomplish their goals. For these clients, there are strategies that can mimic an annuity, or at least provide some downside protection for some upside reward.
Before determining any strategy, advisors need to determine what their client needs. With the demise of the corporate pension plan, clients are in need of a way to build wealth and be able to distribute that wealth as income. This is generally the underlying need, although every person is different.
Avoid the Lockup
Every individual has his own preference regarding risk, returns and fees. Annuities can provide a convenient method of producing income but may not meet some of the client’s necessary criteria.
Therefore, building a portfolio with annuity-like features is beneficial for clients who don’t want to lock themselves up.
For example, I have a client in Arizona who was recommended an equity index annuity in 2009. She received an inheritance of $320,304. The current value of the inheritance today is $321,158, but the cash value of what she can take out after penalties after five years of having the inheritance is $281,350.
If she followed a strategy of CDs plus stocks, she could have had protection of principal and upside growth. For example, she could have invested $281,000 into a CD (let’s lower the rate because the rates were lower in 2009 to 0.50%) and $39,304 into a broad stock market exchange traded fund like the Vanguard Total Stock Market (VTI).
The CD would have increased ever so slightly to $288,095 and the amount invested in VTI would increase to $82,145, or roughly 109% after fees in five years. The total amount would currently be $370,240, a significant increase over the original $281,350.
Now imagine that you purchased the equity index annuity for the guarantee. What if you did not purchase the funds in 2009, but rather in 2007, just before there was a decline in the stock market?
If you were to invest $281,000 into a five-year CD in May 2007, the rate of return would have been 3.7%, (according to bankrate.com). This rate would have generated $10,397 after the first year or $51,985 over a five year span. VTI closed with a price of $76.63 in May of 2007. Five years later, as of May 9, 2014, the price was $97.17, an increase of 27%. Consequently, the value of the CD and VTI mix would be $382,824 today. If you subtract 20 basis points annually for fees, your ending value would be $378, 995.
While this is a reasonable increase, at its depths, VTI declined 57%. Consequently, in March 2009, the value of the combined CD VTI cocktail was worth a measly $312,942. The client would have lost about $8,000 or 3%, which is not exactly principal protected.
Allan S. Roth recently wrote an article titled, Investing Trick: Build Your Own Annuities, in Financial Planning magazine. He outlines this strategy exactly as a replacement for an equity index annuity. He also provides alternatives to an income annuity and a variable annuity.
The point is there are alternatives to investing client’s money besides annuities if they do not like the risk, reward, fees or lockup characteristics of an annuity.
The fun part about finance is that with each product, you can break it down and recreate it. The best part is that if you don’t like a particular attribute, you can recreate the outcomes using other products without the characteristic you don’t like.
Whether a smash hit or a crash is predicted for 2014, you can devise a plan to provide growth and protection for your clients.