Why do people buy annuities? It's a fundamental question every salesperson asks. In this chapter we'll explore various types of clients, their needs, financial objectives and other factors that go into the decision to purchase an annuity.
While it is cliché to state that all clients are unique — and indeed all investors have unique needs and face different circumstances — annuity investors can be classified into four broad categories:
¨ individual investors,
¨ charities, and
Over the course of a human lifetime, an individual's investment objectives will typically pass through four phases: accumulation, conservation, distribution and transfer. In one's younger years, the focus in on accumulation of wealth. Whether it is scraping together a down payment to purchase a first home, putting those first contributions into one's retirement account or setting aside funds for the children's college fund, the goal is to accumulate capital and investments are typically made with capital appreciation in mind. As the investor ages, the objective shifts from appreciation to conservation -- riskier investments that may result in significant investment gains give way to less-risky investments offering safety of principal. As one's working years end, the objective becomes how to assure that the wealth that has been accumulated and conserved can be used to support the investor in retirement. At the end of one's life the focus is how best to pass on one's wealth to designated beneficiaries.
Let's take a look at how annuities (fixed, variable and indexed) can help individual investors in achieving these objectives.
Historically, equity investments offer the greatest possibility of capital appreciation. The term "equity", meaning ownership, encompasses a wide range of investments. It could refer to owning a small business, owning real estate or other tangible assets, or participating in the ownership of large corporations through the purchase of the company's common stock. Equities have tremendous upside potential. Everyone has heard of stories of an investor who purchased 100 shares of a promising start-up company and watched their investment grow into millions of dollars. But it is also true that many investors have put money into companies that have not performed as well, or that have gone out of business. There is a significant risk-reward component to investments in equities. Investment advisors must certainly take into account an investor's tolerance for risk in meeting the objective of capital accumulation. Rather than simply investing in vehicles that offer the possibility of capital appreciation, investors should invest in a manner that maximizes the probability of achieving his or her goals. This may entail investing in a range of riskier and less risky assets — this is the underlying principle of Modern Portfolio Theory.
In the annuity market, investors seeking capital appreciation have two options: variable annuities and equity indexed contracts. Each offer different advantages and disadvantages to investors.
As we discussed in earlier chapters, the investment performance of a variable annuity relies on the investments held in a variety of separate accounts. The contractholder in a variable annuity will select which subaccount(s) he or she would like to invest in. The value of the subaccount will fluctuate in value based on the current values of the investments held within the subaccount. Typically, the subaccounts invest in common stocks, with the expectation that common stocks offer better inflation protection for the investor -- but as with any equity investment, there are no guarantees. The contractholder assumes the investment risk in a variable annuity.
Modern Portfolio Theory holds that the best way to achieve the highest possible returns with the least possible amount of risk is to invest in a broadly diversified portfolio that can be rebalanced periodically in response to changing market conditions (preferably with little or no transaction costs). Variable annuity separate accounts (or investment in a combination of various subaccounts) offer the investor a way to create a broadly diversified portfolio. Most variable annuities today offer a wide range of subaccounts to their contractholders. Each subaccount is a professionally managed portfolio — some are actively managed; others are passively managed. Some variable annuity companies have an exclusive arrangement with a particular money management firm to make investment decisions for its subaccounts. Other companies may offer contractholders a choice of subaccounts managed by different advisory firms. Obviously, the portfolio managers need to be paid, so all of these investment alternatives come at an expense. Almost all variable annuity contracts also will offer a "fixed subaccount" with a low guaranteed rate of return, which acts much like a fixed annuity within the variable annuity contract — and this fixed option comes without any management fees.
It is worth noting that sometimes a variable annuity's subaccount is referred to as a "clone" of a well-known mutual fund. This term can be misleading. For example, a variable annuity may offer a subaccount called the "Stellar Growth Opportunities" managed by Nova Capital Management. Nova may also offer a mutual fund by the same name — but this does not guarantee that the subaccount and the mutual fund are managed by the same person, have the same investment objectives and policies, or share the same underlying investments. Nor does it mean that the fees and expenses are the same. Even in cases when the same professional manages the variable annuity subaccount and the mutual fund, the manager may employ different investment strategies. Tax considerations alone may account for different strategies: mutual funds must distribute capital gains to shareholders annually (which are taxable regardless of whether they are reinvested in the fund or not), while gains realized in the variable annuity's separate account are not distributed. Another difference between the separate account and the mutual fund is in the calculation of the unit or share price. Realized gains in a variable annuity's subaccount are automatically "reinvested" in the account, i.e., realized gains are reflected in the growing "price" or value of a fixed number of accumulation units. By contrast, realized gains that are distributed and reinvested in a mutual fund are used to purchase additional shares -- in other words, the number of shares (not the price) will increase. For these reasons, advisors should refrain from describing a contract's separate account as a "clone" of a mutual fund as it could potentially mislead clients.
According to the Modern Portfolio Theory an investor should invest in a broad portfolio of securities that have weak correlation, that is, they do not behave in lockstep. Ideally, the portfolio will contain some investments that go down while others in the portfolio go up, and vice versa. The assumption is that by holding weakly correlated securities, the investor's risk is reduced, in other words, the investor is protected in good times and bad. Put another way, it is not enough for an investor to diversify his or her portfolio by owning a large number of stocks, but must also invest in different types of stocks that behave differently as the market changes. This is called the "efficient portfolio". A sophisticated investor can construct an efficient portfolio by selecting individual stocks, but trying to build an efficient portfolio by combining separate accounts is a more daunting task. In most cases the statistical data to analyze separate accounts for this purpose (expected mean returns, expected volatility, coefficients of correlation, etc.) are not readily available. Fortunately, advisors can use separate accounts with different investment policies as a "proxy" for an asset class, e.g., Nova's Stellar Growth Opportunities as a proxy of small cap stocks in general. As an oversimplified example, an advisor could recommend investing in a separate account that invests in cyclical stocks in conjunction with a subaccount holding countercyclical stocks. The two asset classes should move in opposite directions during the business cycle, and thus approximate an efficient portfolio.
When combining separate account portfolios in this way, it is useful to make the distinction between actively managed portfolios and those that are passively managed. By definition, actively managed portfolios attempt to outperform the market. This, after all, is what sells the fund to investors and justifies the management fee. However, actively managed portfolios may also fail to match the investment results of the general market. Advisors relying on the Modern Portfolio Theory to construct an efficient portfolio for his or her client will want to seek out funds that mirror the results of a particular asset class. Actively managed portfolios most likely will not meet that need — as the goal of the active manager is to exceed, not to simply match, the market. Advisors seeking to build an efficient portfolio within the variable annuity may want to explore passively managed portfolio options within the contract -- as these are more likely to achieve the results the advisor is seeking. Passively managed portfolios are designed to mirro the performance of a market benchmark, such as the S&P 500. For instance, Nova's "Russell 2000 Index Growth" account is more likely to match the overall investment results of small cap growth stocks, in general, than Nova's actively-managed "Stellar Growth Opportunities” which is trying to beat the general market.
In the past, most variable annuity contracts did not offer many passively managed subaccount choices, but there seems to be a trend toward offering more of them. Some contracts now offer Exchange Traded Fund accounts (ETFs), such as Spiders® and Diamonds® which mimic the results of the S&P 500 and Dow Jones Industrial Average, respectively. Either of these options (passively managed subaccounts or EFTs) will have lower expense ratios than their actively managed counterparts.
For advisors who feel that actively managed portfolios offer added value to their clients (even at the higher expenses) variable annuity contracts may offer the ability to select specific managers or specific management styles to enhance their client's portfolio. Some firms have a "total value investing" philosophy; others focus on growth only. Some firms are expert at fixed-income investments; other concentrate on equity investments. Put another way, a range of actively managed subaccounts allow the advisor to diversify the portfolio not only by investment type but diversify management expertise as well.
One last aspect of Modern Portfolio Theory is that an efficient portfolio should be rebalanced periodically -- to return the investment mix back to it's original percentage allocations, or to reflect changed investment objectives and time horizons -- preferably at little or no cost. Variable annuities typically allow switching funds among subaccounts without cost. Given the tax-deferred nature of annuities, such switches are not taxable events (as they would be in a mutual fund family) — so variable annuities offer a very cost-efficient means to rebalance a portfolio. Many variable contracts offer to automatically rebalance an investor's holdings on a regular schedule (annually, quarterly, etc.) or if the percentage allocation varies from a target by a predetermined amount. This automatic rebalancing is usually provided at no additional charge to the contractholder.
A similar feature, offered by many contracts, is a dollar cost averaging program. This allows an investor to invest a lump sum without fear of investing at the wrong time. The company accepts the full lump sum into the contract’s fixed account and periodically transfers a predetermined dollar amount into the selected variable subaccounts. This has the advantage of purchasing more units when the unit price is low and fewer units at higher prices. The entire sum is transferred evenly over a period of time, usually six months or one year. Mathematically, a dollar cost averaging program will buy units at a lower average cost than the average price of the units over that period.
Indexed annuities, in contrast to variable annuities, do not rely on separate subaccounts of investments. Instead, the annuity issuer guarantees a rate of return based on an equity index, subject to limitations stated in the contract. Put into the context of the proceeding discussion of Modern Portfolio Theory, indexed annuities offer investors a passively managed alternative to the choices presented within variable annuity contracts.
It is important to note that an investor who selects a passively managed subaccount in a variable annuity that mirrors an equity index (e.g. Nova's Russell 2000 Index Growth fund, mentioned above) is subject to investment loss if the index falls. That is not true in the case of indexed annuities. The company issuing an indexed annuity does not actually hold a portfolio that is representative of the index. Instead the issuer will purchase index options. This allows the company to participate in the upside in the market, but not to suffer losses if the market falls. (The contractholder bears the cost to purchase the options by accepting limitations on how much of the index's gain will be credited to the contract. Equity indexed annuities are not a "free lunch" program.)
Thus, the key difference between an investment within a variable annuity and an equity indexed annuity, from the investor's perspective, is that the investor is subject to the full investment results, up or down, that occur in the variable annuity's separate account (net of the management fee), while investors in an indexed annuity will participate only in the upside of any index moves, but those gains are limited by contractual features such as participation rates, caps, spreads, resets, etc. In a way, indexed annuities straddle the investment objectives of accumulation and conservation — which no doubt, accounts for their popularity for a wide range of investors.
As noted in Chapter 1, the index used in most equity-indexed contracts is the S&P 500 index. This index only reflects changes in the share prices of the index’s component stocks — it does not include dividend payments made by those stocks. So the “market return” in an indexed annuity contract will probably not match the total return an investor in an indexed separate account (mutual fund or EFT) would earn.