If you want to start a fight in a room full of financial planners, just bring up annuities. About half the room will argue that these are valuable products that offer guarantees to worried clients, the rest will contend that the guarantees are worthless and the fees are outrageous. But the truth is advisors don’t need to turn to annuity products to allay clients’ fears about market losses.
Put simply, annuities are a contract between an insurance company and an individual. They come in many shapes and sizes, ranging from very simple — such as a single-premium immediate annuity (often called a SPIA) that promises income for life in the form of a monthly guaranteed check — to mind-numbingly complex, like the fixed indexed annuity that promises equity-linked returns without risk of principal.
All, however, are indirect investments made through insurance companies and insurance agents, which profit as intermediaries. And those profits reduce returns for our clients. So to the extent that advisors can help clients achieve annuitylike results while cutting out the intermediaries, the clients are likely to have more money for life.
Here are some methods that will let you build your own annuity to increase your clients’ returns:
1. EQUITY-INDEXED ANNUITY
This annuity promises wealth without risk. It is usually marketed by promising part or all of the “market return,” with a guarantee not to lose principal. But since regulators require the insurance company’s assets to be invested conservatively, common sense dictates that the insurance company can only return a conservative (fairly bondlike) return — less the commissions, overhead and profits the insurance company needs to cover.
Typically, returns are linked to indexes like the S&P 500 stripped of dividends, and have maximum returns — which the insurance company often retains the unilateral right to change. I just reviewed one policy that had lowered the maximum return on an existing policy to 3.5% — meaning my client would get between 0% and 3.5% annually, but had to pay 10% of his principal if he wanted his money back.
It’s a feel-good product — but it’s also a product that you can easily mimic, with dirt-low costs and guarantees backed by the U.S. government. All that your client needs is a high-paying long-term CD and a low-cost stock index fund.
As of mid-April, GE Capital Bank had an FDIC-insured 10-year CD yielding 3.3%. If the clients have $100,000, for instance, they could put $72,276.45 in this CD, which would mature in 10 years at $100,000 — that’s the guaranteed principal.
Then your clients can put the other $27,723.55 into a low-cost total stock index fund such as Vanguard Total Stock ETF (VTI), which has a 0.05% annual expense ratio. In 10 years, the client gets back the $100,000 in the CD plus the value of the stocks, which will also include the dividend reinvestment.
Clients can do even better if they are willing to take on a minimal amount of risk. Let’s face it: If the value of stocks 10 years later were zero, then the U.S. government would probably have failed, as well. So we can do better if we assume rather conservatively that the total return of stocks (including dividends) would fall no more than 50% in 10 years.
In that case, the clients put $56,588.19 in the CD and the other $43,411.81 in the stock index fund. If it’s a horrible decade for stocks, in which the S&P 500 loses 60% of its value, the total stock fund with dividends reinvested would lose about half its value, and the client CD plus that stock (at half the original value) would be worth $100,000.
But here’s the upside: If stocks return 8% annually over the next decade, the guaranteed combination will earn 4.8% annually, while the “virtual guarantee” combination (which assumes stocks lose no more than 50%) earns 5.57% annually.
The How DIY Fares chart above breaks down the approximate returns based on how stocks actually perform. The do-it-yourself options are actually far superior to an equity-indexed annuity.
They can also be more tax-efficient. If the client buys the CD within a tax-deferred account, such as an IRA, but leaves the stocks within a taxable account, the stock dividends will be taxed at a lower rate and the capital gains will be deferred until sold — when they are also taxed at a lower capital gains rate.
2. INCOME ANNUITY
Clients seeking longevity insurance often turn to annuities to get a guaranteed monthly check — either via a single-premium immediate annuity or with a deferred life annuity (sometimes called a deferred immediate annuity), which defers the start of those monthly payments to some specified date in the future.