Variable Annuities should come with a 2-word review "Shit Sandwich"
Nigel Tufnel: "They can't print that!"

Annuities Rant, Part I – On Complexity

Fixed rate annuities, fixed index annuities, variable annuities – how do I hate thee? 

I’m not recommending this book. I haven’t read it. I just like the double-entendre of “Cons” = Convicts and “Pros = Only professional salespeople could like this.

Let me count the ways, for they are plural.

Let’s start with annuities’ complexity. In a future post I will address their mediocre returns and high fees. 

Complexity matters because of a basic rule of financial products I just made up which, if you read it out loud, will sound a lot like your Miranda Rights:

“You and your money have the right to simplicity. Whatever you can’t understand can and will be used against you by the financial service provider.”

Annuities come in three main flavors. 

The vanilla flavor – fixed rate annuities – are actually decently simple. These are not evil. You give money to the insurance company, either all at once or over time, and they agree to give you back your money in equal monthly payments, either for a fixed amount of time or more typically for the rest of your life, guaranteed. The only fancy complex math going on in the background of fixed rate annuities is an actuarial guess about when you’ll die.

The other two flavors – the confusingly named fixed-index annuity, and its close cousin the variable annuity – are far more complex. Their structures vary from company to company, so in describing them I can point out the possible complications, but the specifics will be hidden from you somewhere in the fine print of your contract. Like an Easter egg hunt, but far, far more costly.

The other flavors start out with opaque calculations as the insurance company collects your money over time. At some point when you’re done giving money over they morph into a simpler fixed annuity. In this way, the fixed index and variable annuities are like hungry fuzzy caterpillars, disgusting to look at. Eventually, however, they annuitize and become simpler fixed rate annuity butterflies.

In prepping this review I read every word of some of the most boring variable annuity product plan documents you can imagine. Three different company contracts from 2008, 2014, and 2018, plus The National Association of Insurance Commissioner’s Buyer’s Guide To Deferred Annuities.

So, about the complexity of fixed index annuities, and their variable annuity cousins. Both give the buyer exposure to “the market,” but in an indirect way.

With a fixed index annuity you give your money to an insurance company and they promise to credit your account with some of the gains associated with a stock market index, such as the S&P500 of large cap companies or the Russell 2000 index of small cap companies. But exactly how they do that is usually calculated in a complex way. The basic value proposition from the insurance company is that they say you can participate on the upside when the stock mark appreciates, but they will provide some protection from loss when the stock market drops below the amount you put in, or drops below the previous year’s highwater amount. It’s a kind of “some market upside and some safety” combo platter. Sometimes that protection is against a 10% drop in the market, sometimes it’s against any loss of principle.

But how do they provide this “safety?” A bunch of ways. Sometimes the contract limits your upside by a “participation amount,” like 80% of the index gains. So if the market index returns 10%, you get credit for just an 8% annual gain. Another feature might be a “performance cap” that limits the amount an insurance company will need to credit you with, in a bull market. The market went up 12%? Sorry, your gains are only 9%. You might pay a “Spread Rate” which is a % of market gains, by which your insurance company subtracts your returns. Spread Rate doesn’t sound like a fee, but that’s what it is.

A particularly devious way to limit your returns is to only credit the price change of an index, but not the dividends you would have received if you owned the index in a brokerage account. As I’ll explain in a future column, that might mean you’ve left half your gains on the table.

with guaranteed benefit riders. Helping to Protect your Income. in Unpredictable Markets. Variable Products: Are Not a Deposit of Any Bank • Are Not FDIC Insured by Any Federal Government Agency • Are Not Guaranteed by Any Bank or Savings Association • May Go Down in Value. ML

How does the company handle all this complexity? 

As Jefferson Bank’s contract clearly states, “Subsequent Accumulation Unit Values for each Sub-Account are determined by multiplying the Accumulation Unit Value for the immediately preceding Valuation Period by the Net Investment Factor for the Sub-Account for the current period.”

It goes on like this for a couple of pages. I’ve read all the words and my head hurts.

Let’s go to the AXA Equitable document, to figure out our “Guaranteed Annual Withdrawal Amount” or (GAWA). Well, you see it’s, the, um:

  1.  “The sum of contributions that are periodically remitted to the PIB variable investment options, multiplied by the quarterly Guaranteed Withdrawal Rate (GWR) in effect when each contribution is received, plus
  2. The sum of (i) transfers from non-PIB investment options to the PIB variable investment options and (ii) contributions made in a lump sum, including but not limited to, amounts that apply to contract exchanges, direct transfers from other funding vehicles under the plan, and rollovers) that are allocated to the variable investment options, multiplied by the Guaranteed Transfer Withdrawal Rate (GTWR) in effect at the time of the transfer or contribution, plus
  3. The sum of any Ratchet Increase.”

Got it? As the teens would say: “Ratchet, dude”

Ok, here’s what you do need to know. You can’t independently observe their math. You own rights to a complex derivative – that’s not what they call it, but that’s what it is – and only they can tell you what that derivative is worth.

Variable Annuities should come with a 2-word review “Shit Sandwich”
Nigel Tufnel: “They can’t print that!”

With a regular brokerage account, by contrast, you would see an observable market price for a mutual fund, or a stock or a bond, or an ETF. 

Remember, anything you don’t understand can and will be used against you.

Do you want your money back yet? You can’t have it. 

Generally once you’ve annuitized, you can’t accelerate or change your fixed rate annuity. Prior to annuitization, you can have some, but you will probably pay surrender or withdrawal charges on any fixed index or variable annuity that you want to get out of. You may be able to get 10% of your money back each year without penalty, but for additional money you should expect to pay a 5% fee under many contracts, with a slowly declining penalty amount per year.

So that’s the story on complexity and illiquidity. I’ll tell you next time about the bad returns and the high fees.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts

Annuities Rant Part II – Low Returns, High Fees

Annuities Rant – Part III – I partly take it back, but not really

Ask an Ex-Banker about Annuities – Death Eaters

Variable Annuities – Shit Sandwich

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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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