Why do people buy investment annuities?
It’s a good question, particularly since many financial writers hate them like poison. These scribes seldom make any kind of persuasive case against investment annuities (often referred to as variable annuities), however — probably because they don’t understand taxes and tax theory, and because they don’t “get” the ease of trading.
I know, I know: The standard answer to my question is because they are sold. It’s a valid argument, but is that all there is to it? Is it the whole enchilada? I know people who buy investment annuities for other reasons, without being called on or sold by sales people. Indeed, some investors seek out investment annuities on their own; if a registered representative is involved, it’s to satisfy legal requirements, not because of a sales presentation.
Vanguard, the famously low-expense mutual fund company, offers an investment annuity with low fees and zero sales commissions. It’s hard to tell about how many people buy Vanguard annuities — the contracts are actually issued by insurance companies that have agreements with Vanguard — but surely people buy, since the annuities are still present on Vanguard’s Web site. Inviva, through its former subsidiary, American Life Insurance Company of New York, once offered an online variable annuity. Inviva seems to have shifted from the direct-to-consumer American Life of N.Y. product to an advisor-driven annuity offered through its Jefferson National subsidiary. Still, the advisor product is very low-cost and no sales commissions are involved; advisors who use it are compensated by fees.
One of the top annuity companies in the world, TIAA-CREF, does a tremendous volume of annuity business with teachers, and now some products are available to non-teachers as well.
If you want to know all about investment annuities, read any of John Huggard’s books, or go to one of his seminars. I’ve written about John in this space before. An attorney, college professor, and prolific author, he is the “go-to” guy for investment annuity information, including tax calculations. Let’s look outside Professor Huggard’s work this time, though, since it could be considered somewhat biased in favor of investment annuities.
More about “variable”The “variable” title, by the way, has little to do with the ups and downs of an investment annuity’s value. It has everything to do with units and retirement benefits. The original idea was for variable annuities to provide a monthly retirement benefit that could keep up with inflation. A retiree could take all of his or her monthly unit income from sub-accounts, in which case the monthly income would “vary” up or down, depending on the performance of the underlying investments. A second option was to take some income from a fixed account and some from investment sub-accounts, providing a base floor from the fixed, and using the investment sub-accounts to nominally keep up with inflation.
As it happens, few people take income from variable units when they retire, and they are not using them to combat inflation. Instead, investment annuities — at least in the private sector — have become accumulation vehicles with living benefits. It’s not that people don’t take income, although many don’t; it’s more that they don’t take income in a variable way.
I’m more interested in trying to understand why people buy investment annuities. With that thought in mind, consider David Swenson’s
Unconventional Success — a Fundamental Approach to Personal Investment. Dr. Swenson does not discuss investment annuities at all in his book; in fact, I’m not sure the word “annuity” appears even once in its 402 pages. He does discuss taxes, however, and he argues (quoting MIT economist Dr. James M. Poterba) that from 1926 through 1996, the average tax burden on large-cap stocks was 3.5%. So, if you earned a return of 12.7%, pre-tax, only 9.2% found its way to your pocket. (This assumes buying and selling stocks over time, with a mix of long-term and short-term capital gains, in contrast to the Warren Buffett model of owning one stock forever. In the Buffett model, virtually no taxes are paid because the stock is never sold, and shares of Berkshire Hathaway have never paid dividends.)
At the current 15% tax rate on long-term capital gains and dividends, if you invest in a portfolio of traded stocks or mutual funds, you could pay an estimated 15% to 20% of the return in taxes (remember, not all investments pay dividends or generate gains), assuming 10% growth and some tax efficiency, trading only after holding most stocks for at least 12 months. (With mutual funds, you are at the mercy of the fund, and there is usually a mix of net short-term gains and dividends to contend with). If you do short-term trading, triggering ordinary income tax rates, the story is far worse, since such taxes could range from 25% to 30% or more. In that event, the combined federal and state tax burden could eat up one-third of the gain, and turn a 10% gross yield into 7% net. (This does not, however, dissuade the many short-term traders out there.)
It is probably safe to say that most people who own mutual funds, trade stocks, or do some of both, pay somewhere between 10% to 20% in annual taxes on their holdings. People who own a stock forever, like Warren Buffett, pay no tax, unless the stock pays dividends, and, as previously discussed, Berkshire does not. As a general rule, we could estimate that a 10% return on investments would net down to between 8% and 8.5%. If you add trading costs and internal expenses, it would be less. Although those charges are paid, I ignore them here because they seem invisible — the fund company does not really say, in understandable prose, we earned 12% gross, and the investors’ share is 10% after expenses. (The fund companies do ultimately say that, but it’s difficult for laypeople to understand that 10% isn’t always 10%. Explanations of fees and commissions are delivered in prospectusese, a language of obfuscation that makes full consumer understanding virtually impossible. David Swenson, in
Unconventional Success, lambastes mutual funds for a variety of sins, and he’s mostly dead-on correct about the absence of clarity.)
Enter the Investment AnnuityTake away the living benefits, the death benefits, and other emollients, and the investment annuity offers the following primary advantages over other investments.
Trading ease. You can manage the investment sub-accounts within the annuity easily, and there are no trading charges or commissions involved for moving money between sub-accounts. Transfers are somewhat restricted, however, mostly due to a very broad interpretation of the lawsuits brought by Elliot Spitzer, during his tenure as attorney general of New York, against the preferential after-hours trading by some sub-account managers. In effect, the sub-account managers figured out a way to do something that they always wanted to do — make it harder to trade inside investment annuities — and the insurance companies, often clueless about investing, went along. (Since the advent of the restrictions, some companies have added Rydex, ProFunds or Direxion sub-accounts for frequent traders.)
An assortment of investment choices. Although the investment choices some companies offer are dismal, or restrict advisors as to portfolios, some products are more flexible and have terrific choices. Check Allianz, Genworth, Prudential, and ING, among others, for investment flexibility.
No tax to pay. You pay no tax until you take money out of an investment annuity. Gains and dividends, left alone, are not taxed. There are taxes to pay — at ordinary income rates — when money comes out, but that usually isn’t necessary until retirement. This allows you to plan ahead and control taxes. Example: You make too much money in 2009, and find that you need to take $5,000 as a one-time withdrawal in November. Instead of taking it in November, you borrow $5,000 from your bank, and then repay the loan with a new withdrawal in January 2010, a year in which you don’t expect so much income.
Taxes at retirement. If you use the annuity as it was intended, to provide variable and/or fixed monthly lifetime income through annuitization, it may — assuming it is non-qualified — offer significant tax breaks on income.
Protected property. In many states, investment annuities are protected property, meaning that it’s difficult, and in some cases practically impossible, for creditors to get at them in bankruptcy cases.
Variable investment units. They are there, if you need or want them. Actually, using variable investment units to keep up with inflation during retirement is a pretty good idea, particularly if you mix fixed and variable together.
Manageable expenses. If you forego living and death benefits, which can be expensive, an investment annuity can be a superior alternative to taxable investments, especially considering the tax advantages during accumulation. Some annuities — Integrity for one — are using hybrid ETFs, which have remarkably low expenses. Jefferson National, discussed earlier, has an advisory annuity with expenses of $20 per month. Nationwide, Prudential, Security Benefit, and Midland National, among others, all have interesting annuities suitable for trading, and some have low expenses.
This list makes a strong case for investment annuities, and I didn’t even include living or death benefits. When you strip away all the noise and marketing hype and focus on the basics, these products make a lot of sense.
Broker’s Bookcase Road Rules — Be the Truck, Not the Squirrel: Learn the 12 essential rules for navigating the road of life, by Andrew J. Sherman (Elevate/Advantage Media Group, 2008)
Sherman is an attorney-partner in the law firm of Jones Day in Washington, D.C. and a professor in the business school at the University of Maryland. This is his 17th book.
You may have learned everything you need to know about life in driver’s education. Did you pay attention? Sherman suggests that you think about it. For example, in driver’s ed, we learn “… when to speed up and when to slow down; when to yield and when to come to a complete stop; when to add gas and when to add oil; and when and how to communicate when it is not clear who has the right of way.”
That list is abbreviated, but enough to illustrate the idea: “The rules that we must follow to maintain our driver’s licenses — our privilege of sharing the road with others — are the same rules we need to embrace to lead an enlightened and productive life.”
Sherman lays the responsibility for your own life story squarely on — you guessed it! — you. He writes, “We spend most of our lives devoted to activities that diminish our faith and then wonder why our tank is empty.” I learned some great life lessons from
Road Rules, and — I hate to admit it — some good tips for adjusting my driving attitude as well. Thanks, Mr. Sherman.
Readers may write to Richard Hoe at Richard Hoe Investments, LLC, 7134 South Yale Avenue, Suite 560, Tulsa, OK 74136, or email him at richardhoe@richardhoe.co . Mr. Hoe has been an investment professional for 40 years, and is a registered representative and investment advisor representative. He has been writing professionally for more than 50 years, and is a member of the adjunct faculty at the California Institute of Finance, a graduate school at California Lutheran University that offers an MBA in financial planning. He holds five designations, including, Chartered Financial Consultant, Chartered Life Underwriter and Accredited Estate Planner.This information is intended for financial professionals only, not the general public. This is not a solicitation to buy or sell any specific security. Mr. Hoe may have positions in the securities or other investments discussed.