Hybrid annuities: High value or just hype?

In the past two columns in this series, I wrote about two of the most common types of annuities: variable annuities and immediate annuities. Both of these types of contracts have contributed to the bad taste many people seem to have about these products.

While we do have legitimate uses for immediate annuities (even though they require you to commit “annuicide,” i.e., give up control of your principal), I can’t think of any reason for anyone to purchase a variable annuity.

I’m not alone in that opinion: None other than John Biggs, former chair of TIAA-CREF, is quoted as saying in Jane Bryant Quinn’s column “One Faulty Investment” (Newsweek, Aug. 30, 2004), “I cannot imagine a personal financial situation where I’d recommend a VA as a good idea.”

However, there is a new breed of annuity that has grown up over the past 20 years in response to the very specific retirement needs of the baby boomer generation.

This is called the fixed-index annuity, and it is being used successfully by thousands of advisors and millions of retirees to provide safe growth and guaranteed income that one cannot outlive.

How do these contracts work, and do they live up to the hype?

First, it’s important to note that while they have some of the characteristics of VAs and immediate annuities, they are neither.

In fact, what they are is a combination of some of the best attributes of fixed annuities, VAs and immediate annuities, without many of their drawbacks.

An FIA is first and foremost a fixed annuity. Fixed annuities and life insurance are regarded by most financial experts as among the safest financial instruments available. They rank with government-insured CDs and bank deposits, T-bills and other government-backed securities in terms of safety.

In fact, a case could be made that they are even more secure. While the FDIC doesn’t have anywhere near the resources to cover all of its potential liabilities (other than the ability to print money), the insurance industry is required by law to hold 100 percent of its liabilities to its fixed policyholders.

Indeed, it was this rock-solid system that bailed many people out of the Great Depression, as people’s insurance policies were the only assets they had that did not crash.

As a fixed annuity, these products are not only safe; they are also generally not very high-performing, though compared to the other safe money alternatives, they are quite good.

For example, today’s CD rates are around 1 percent, while today’s fixed annuity contracts can yield in the range of 3-3½ percent. However, we are Baby Boomers, after all, and through the 1980s and ’90s we were conditioned to expect much higher returns, so these amounts weren’t that appetizing.

In answer to this, the original fixed-index annuity was introduced in 1995. The notion was to have a fixed product where your principal and earned interest were never placed at risk, but would provide alternative ways of crediting interest that provided for potentially higher rates of return.

By utilizing just the interest that would normally be paid – currently in the 3 percent range – to purchase call options in the market, the annuity could enjoy a portion of the market upside without ever placing the principal at risk.

It turned out to be a brilliant combination, and, according to a Wharton Business School study conducted by Professor David Babbel and released in 2010, “The returns on FIAs outperformed the alternatives over the lifetime of their existence (since 1995) for every year that they have been issued.” This is the power of eliminating downside risk to one’s portfolio.

This becomes especially important during the spending phase of one’s retirement. As opposed to the accumulation phase when dollar-cost averaging can have a positive impact, reverse dollar-cost averaging, which happens when assets are decumulated, can have a very negative effect on a retirement account.

Selling off during down markets results in an increased burn rate and reduces the amount of “bounce back” available during market recoveries, and over time can reduce the amount of income available to the retiree.

This is exactly the reason that the widely accepted Monte Carlo planning model used by many financial planners restricts spending to 4 percent, or even lower, and provides a relatively low (80-90 percent) success rate in the process.

So the elimination of market risk while preserving decent gains has had a huge impact on retirement planning, but that’s not where the story ends. Another major problem that imperils retirement planning is longevity risk.

Next month, we will look at what the ability to eliminate longevity risk, in addition to market risk, can mean to an income plan.

“Free Money Guy” Stephen Kelley can be heard, along with his co-host Mark Perkins, on the Free Money Radio Hour at 9 a.m. every Tuesday and Wednesday morning on 1590 AM WSMN in Nashua. His financial planning practice, Safety First Financial Planners is located at 33 Main Street in Nashua.
He can be reached at 881-8811.