Investors & Objectives
The second investment objective most investors have is conservation. Accumulation is the process of acquiring capital; conservation is the process of keeping it. This is the natural consequence of the aging process. Accumulation of capital — and the risk that entails — begins in early years when the investor's investment horizon is reasonably long. As we age, that timeframe inevitably shrinks. The time available to recover investment losses diminishes, so the focus of the investor changes to retention of the capital that has been acquired. "Safety of principal" sums up this objective.
While poor investment performance is the most obvious reason for loss of capital, losses can also arise from a variety of other reasons: taxes, insolvency of the institution holding the investment, or attacks by creditors. Annuities, of all types, can assist an investor in meeting the objective of conserving capital.
Fixed annuities, which offer a guarantee of principal, are the most obvious choice for those seeking conservation. The investor's principal is paid to the company, and the company invests those funds in its general assets. The company must pay the investor the guaranteed rate of return, regardless of the investment results earned in the company's general assets. In a fixed annuity, the company issuing contract bears the investment risk, the investor’s principal is guaranteed.
As with all annuities, growth in the fixed annuity investor's account is tax-deferred. In many other investments, such as stocks and mutual funds, periodic distributions of income are subject to taxation. These periodic distributions can, in many cases, be reinvested (automatically or "manually") and the investor can experience compounding interest -- earnings on earnings. In a taxable investment, only the after-tax portion of the distribution can be reinvested or compounded. In a tax-deferred annuity, all earnings are available for compounding. This is sometimes called "triple compounding" — the principal earns interest, the interest earnings interest, and the portion that would have been payable to the taxman earns interest. Fixed annuities, during their accumulation periods (when accumulation and conservation are paramount) are very tax-efficient. (As we'll see later, annuities may not be as tax efficient when proceeds are distributed during the annuity period.)
All investors should be aware of the extent to which they may lose money as a result of the bankruptcy (or other failure) of the institution that holds their money. Advisors can use the ratings organizations discussed in the previous chapters to assess the current financial strength of insurers and annuity companies. In addition, state regulations require issuers of annuities to maintain adequate reserves based on standard actuarial assumptions. That said, assets held in the general assets of an insurance or annuity company are subject to the claims of the insurer's creditors (including the contractholder). Advisors must be aware, and be careful to disclose to clients, that insurance and annuity companies are not depository institutions in which accounts are federally insured. Implications to the contrary are considered by state regulators to be serious misrepresentations of the contract and could result in revocation of the advisor's insurance license. All states do have "guarantee funds" to reimburse owners of life insurance policies and annuity contracts for losses resulting from an insurer's insolvency. Florida’s Life and Health Guaranty Association provides coverage of up to $300,000 per life or health policy ($100,000 cash value) and $300,000 for fixed (but not variable) annuity contracts. Florida law prohibits agents from referring to this protection in their sales presentations.
Annuity contracts of all types, in Florida, are provided special protections against creditor claims. These are discussed later in this chapter.
Much of the foregoing discussion of fixed annuities applies equally to equity indexed annuities — from a purely regulatory perspective, indexed annuities are fixed annuities. Unlike traditional fixed annuities, indexed annuities offer the opportunity to participate (albeit partially) in the upside of market advances while protecting the investor from the downside. In that regard, equity indexed annuities have tremendous appeal to investors concerned with conservation of principal.
As discussed above, variable annuities subject the investor to the possibility of investment losses due to poor investment performance. As the variable annuity investor's objectives change from accumulation to conservation, the investor can switch from subaccounts that aggressively pursue capital growth to other, less risky subaccounts. While that may mitigate losses due to poor investment management, it will not eliminate it -- investments tied to the stock market will inevitably feel the effects of a severe market downturn regardless of the expertise of the manager. Newer variable annuity contracts contain several risk management features from which the investor may choose (at an additional premium) to lessen the effects of a bear market:
¨ guaranteed minimum accumulation benefit (GMAB),
¨ guaranteed minimum income benefit (GMIB), and
¨ guaranteed minimum withdrawal benefit (GMWB).
Newer combination riders, incorporating all three "living benefits", provide all of these assurances with greater flexibility. These three riders were discussed in greater detail in Chapter 1.
Variable annuities also provide a minimum guaranteed death benefit, in effect protecting the investor's principal for the investor's beneficiaries, regardless of the investment experience in the subaccount. Enhanced death benefits can provide addition protection, for an additional fee.
As was the case with fixed annuities, variable annuities grow tax-deferred. During the accumulation period, earnings in a variable annuity's subaccount grow through "triple compounding" of interest. This is one of the key features of deferred annuities -- and as long as the principal remains in the contract, the tax deferral works to the advantage of investors seeking to conserve principal.
Regarding the insolvency of the issuing company, an investor in a variable annuity is in a distinctly different position than a fixed annuity holder. Investments within the separate account of a variable annuity are, as their name implies, separate from the general assets of the issuing company. The separate accounts are not subject to the general creditors of the issuing company. In other words, the assets held by the separate account are reserved exclusively for the investors in that separate account. There is, of course, no guarantee that the assets in the separate account will fully reimburse the accountholders — but, at a minimum, there will be assets dedicated solely to the separate accountholders. It is important to note that there is no legal mechanism such as a state Guaranty Fund to reimburse variable annuity holders, nor are variable annuities subject to the reserve requirements that apply to fixed annuities. Simply put, the only thing backing the investment in a variable annuity issued by a failed company is the portfolio held by the separate account(s) selected by the investor.
At some point in the investor's lifetime, the investment objective will change from acquiring and conserving wealth to distributing it. Some assets are easier to liquidate than others. Real estate and ownership interests in small business can be particularly difficult to liquidate. Annuities, by their very nature, are designed to provide a stream of income. Annuities — fixed, indexed or variable — are the only investment options that can be converted into income payments lasting a lifetime. The concept of an income that cannot be outlived has given comfort to many investors. In addition to the possibility of annuity payments, annuity contracts may also be liquidated, in whole or in part, during the accumulation period. (Once the contract is annuitized, however, the contractholder loses this option.) Large withdrawals in the early years of the contract will most likely be subject to surrender charges, although most contracts will allow penalty-free withdrawals up to 10% of the account's value. In addition, withdrawals from deferred annuities prior to 59½ face a 10% tax penalty. With those caveats, for investors concerned with distributing wealth during their lifetimes, annuities are an ideal investment.
Fixed annuity payouts provide a guaranteed income stream, paying a fixed amount periodically. The size of the payout depends on the value in the account, the interest earned in the contract and the projected actuarial length of the payout period. The fixed nature of the payments can be an advantage or not. Fixed annuities are the only situation in which income is guaranteed for the length of the payout period (usually a lifetime), but the fixed payments are subject to purchasing power risk.
A few (very few) insurers offer contracts that have a true cost of living adjustment tied to an external index of inflation (such as the Consumer Price Index, or CPI). Some insurers do offer fixed contracts in which the annual payout is increased be some stated percentage, usually 1-3%. This may or may not be enough to offset inflation. For the inflation fearful, this feature may be better than nothing, but it is probably not what they would prefer. Advisors should be aware that the initial annual payout for annuities containing an adjustment factor will be less than that of a level one. The greater the guaranteed annual increase, the greater this difference will be. Often, these types of contracts do not contain all of the features that might be offered by the issuer's traditional fixed contracts.
Variable annuity payments are not guaranteed. They, instead, fluctuate based the investment experience of the selected separate accounts. The intent is that, over time, the payments will increase to offset the effects of inflation — but this is a not guaranteed. For those concerned with inflation protection, the current choices are variable annuities (which may perform better or worse than the inflation rate) or inflation-adjusted fixed payouts. The decision is a personal one, based on expectations for future inflationary trends and the degree of protection the investor desires. Many retirees will want to "do better each year" (in real dollar terms), and for these investors, the variable annuity may make more sense.
Riders such as the minimum guaranteed withdrawal benefit (MGWB) and minimum guaranteed income benefits (MGIB) discussed in Chapter 1 could also allay fears over declining variable payouts. The MGIB links variable annuity payments to a guaranteed benefit base that is unaffected by losses within the annuity's separate account(s). This benefit comes at an additional cost: there is a premium for the rider, and usually the rider requires annuitization using payout factors less attractive than those available to contractholders who do not elect this benefit. The GMWB provides similar protection against downside market movement if the contractholder wishes to periodically withdraw funds from the account prior to annuitization — again, at an additional cost.
For investors in variable annuities who wish to have the guaranteed income of a fixed annuity, most variable contracts will offer that as an option. If a variable contract does not have that option, the investor can exchange the contract tax-free under Section 1035 for another contract that does offer a fixed (or an inflation adjusted) payout.
It is important to note that all annuity contracts contain a guaranteed payout schedule at the time they are issued. In many cases, those guaranteed schedules result in annuity payments that are less than could be obtained from newly-issued contracts for immediate annuitization. Investors may use Section 1035 to exchange an existing contract for new one with a more favorable payout schedule.
The final investment objective is to transfer one's wealth to intended recipients as efficiently as possible. Annuities contain survivorship benefits that accomplish that goal. All contracts will contain a minimum death benefit payable if the contractholder dies prior to annuitization. In a fixed annuity, that amount is usually the value of the initial contribution to the contract plus interest credited to the contract. (For indexed contracts, the death benefit will be based on the greater of the guaranteed minimum rate of interest or the equity-linked rate.) In the case of most variable annuity contracts, the guaranteed death benefit is the greater of the initial investment or the current value of the separate account on the date of death. This can be a comforting thought if the value of the separate account has declined since the contract's inception. Most contracts waive any surrender charges upon death. Many variable contracts today will offer enhanced death benefits -- sometimes this is a pure add-on at an additional premium, sometimes the enhanced death benefit is incorporated into the standard contract by charging a higher mortality charge. Typically the enhancement will ratchet up the value of the guarantee to reflect the separate account's value on certain anniversary dates ("as of the 5th, 10th, 15th, etc. year of the contract") or the contract will provide for the guaranteed death benefit to increase by a stated percentage (e.g. 5%) per year.
As a life insurance product, death benefits payable under the annuity pass "by contract" to the designated beneficiaries, bypassing the often cumbersome probate process. In many cases, the contract may allow the holder to choose to restrict when and how the beneficiary will receive the death benefit proceeds. This is helpful in cases when the contractholder wishes to limit access to the proceeds. Usually companies will permit the contractholder to select a periodic payout method on behalf of the beneficiary or limit the amount that the insurer will release each year to the beneficiary. Note: As helpful as the guaranteed death benefits are, they generally only provide return of principal to heirs. They should not be viewed as a substitute for life insurance.
If the contract has been annuitized using a payout method other than a straight life payout, the remaining annuity payments will be paid to the beneficiary until the end of the annuity period. Again, these are paid directly to the beneficiary without the cost and delays associated with probate.
In summary, annuities can be used to meet the various investment objectives of most individuals as they age — be it accumulation of wealth in the early years of one's lifetime or the efficient distribution of those assets in later life (or upon death).