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Annuities - Under the Hood

Annuities - Under the Hood

June 19, 2022

Hi everyone, and welcome back to Melissa Making Cents!


The good news is that we'll never run short on topics for the blog. Finance never sleeps, and it seems there's constantly more to talk about. CERTIFIED FINANCIAL PLANNERS and financial advisor representatives often struggle to keep their clients fully updated about everything going on in the market. That challenge is is exacerbated by many wanting to change their financial plans because of emotional decisions around rising gas prices, inflation, etc.


The last thing you want to do when the market begins shifting is panic. Panicking is how many people lose a lot of money when things get a little shaky. But, in my experience, one of the best ways to prepare for market fluctuations and bear markets is to educate yourselfAnd, as we discussed last week, something that gets really popular during market downturns is annuities! 


Last week we talked about what annuities are, how they work, and the different types of annuities. However, this topic is more significant than just one article, and it's more important than ever to explore and dissect what's going on with annuities. So, without further ado, let's go ahead and tackle this week's subject… how annuities REALLY work. 


Annuities Recap

Melissa Cox CFP  gives a recap of annuities

I want to start this article with a semi-brief recap of the basics. To understand how annuities really work, we first need to understand what an annuity is, why they're popular in bear markets, and what they do. And as I don't want anyone to get left out of this bulky yet juicy topic of discussion, I think a little recap can't hurt.


Read the Annuity Recap

Firstly, what's an annuity? Well, an annuity is a complex form of insurance. In fact annuities are often falsely marketed or represented as investments instead of insurance contracts.   It is a contract between the annuitant (the person who invests in the annuity) and the issuer (the company/carrier who sells the annuity to the investor). With an annuity investment, you agree to pay X dollars to the issuer for X amount of years, months, or as a single premium(lump sum). In return, you're typically given several guarantees about how what you'll receive as your annuity matures. Often, annuities are tied up in some form of retirement account, also called a "qualified" account, which may penalize you should you withdraw your money before a certain age. One thing that sticks out to many is that an annuity is typically sold by an insurance company.


Annuities, and their commercials, gain a lot of attention during periods of prolonged market instability. This is partly because people are pulling money from their investment accounts in the volatile stock market and because annuities make several promises and guarantees that seem too good to be true.


Annuity Guarantees in THIS Market? What's the catch?

Melissa Cox CFP talks annuity guarantees


It seems too good to be true. Where have I heard that phrase before? Most of the time, wedged right between "If" and "it probably is." Salespeople who sell annuities won't want you to dig too deep into them. They won't want you to ask anyone other than them questions about annuities, guarantees, riders, or anything else. I'm not saying that all annuity salespeople are sketchy or even that all annuities are bad. However, I beg you to please contact your financial planner or financial adviser representative before you tie your money up in one.


Some of the guarantees that come with the investment in an annuity are guaranteed income, which promises a specific amount of money to be paid out during retirement. However, as we discussed last week when talking about the guarantees of annuities, the issue is that some of these guarantees are more marketing than finance. For instance, a guaranteed rate of return typically promises sky-high rates with zero fluctuation risk. However, when you dig into it a bit more, the rate of return is generally based on growth rather than cash value. Even with an income guarantee, the reality can be less exciting than the promise. This is especially true when you weigh the long-term opportunity cost of investing in something that fluctuates with the market but can pay out more over time than a fixed annuity.


These guarantees also come with the built-in trade-off that you're signing onto quite a lot of fine print. For example, the fee schedule for annuities can be very high. In addition, some come with multiple fees, like administration, mortality expense and management fees. Though these fees may be a small percentage of your investment or return, they add up over time, and there can be so many of them.  


But in a bear market, or a market where people would rather sell their investments/stocks rather than hold them, how can we not  wonder about some of these promises and guarantees?


Are Annuities Actually Guaranteed?

Well… here's one of the real kickers. Annuity funds aren't guaranteed by the FDIC (Federal Deposit Insurance Corporation). The  FDIC backs financial institutions, like banks, which ensure your money if a bank becomes insolvent. Instead, annuity carriers are regulated by state insurance commissions, which means that their rules and legal obligations differ from state to state. This means that should the institution or company selling you your annuity goes under, you may have minimal options for recourse.


Now combine that with what we already know – when do annuities typically become popular? During market downturns or bear markets, people are aching for guaranteed returns instead of the volatility brought to investors by the stock market. Two implications come with this combined information, in my opinion: 1. You may invest in something you believe to be guaranteed and backed by the federal government, which isn't the case, and 2. These companies could be taking advantage of your fears to raise their own profit while limiting or promising high rates of return that may be uncertain.


Melissa cox CFP suggests investigating an annuity before buying

Remember that not all insurance providers or annuity brokers are created equal. Therefore, it is of the utmost importance that you work with your financial professional to deep dive into the background of any broker you're considering purchasing an annuity from. Because guarantees typically fall on the insurance company or carrier of the annuity (and may not be backed up by regulation). Insurance companies don't normally go insolvent and leave annuity holders high and dry. Still, if were purchasing an annuity, I would want to be sure that it was from an institution with an excellent track record and credit rating. Again, although it's unlikely, insurance companies have gone bust in the past.


According to FINRA, those who want to buy a fixed annuity should check in with their state insurance commission to ensure that the broker is registered to sell insurance in the state and ask about guaranteed protection that the state offers. I also highly recommend meeting with your financial professional and reading the prospectus, which is a document containing benefits, options, charges, and fees. You want to make sure that this investment is in your best interests.


Insurance Companies are the Largest Holders of Bonds

Melissa Cox CFP explains the relationship between bonds and annuities

Many people are unaware that insurance companies are the largest holders of bondsIf you're unaware, bonds are a basically IOU's issued by corporations or governments that pay interest, either variable or fixed. Bonds are typically seen as a safer form of investing than stocks but aren't totally risk-free.


Learn what bonds and annuities have in common

At a certain point, bonds "mature." When this happens, the total principal of the bond must be paid back to the investor. Bonds may also be purchased at a discount. 


It just so happens that insurance companies, often the sellers of annuities, are some of the largest holders of these bonds, as I said earlier. You'll see why that's important in just a bit.


Insurance Companies Use Duration Matching

Melissa Cox CFP explains duration matching


If you're unsure what duration matching is, don't worry – most don't. However, it's important when discussing how annuities actually work.


First, let's discuss what Duration is. According to xplaind, "Duration is the weighted-average maturity of the cash flows of the debt or asset. While duration-matching doesn't eliminate the interest rate risk, it can manage the exposure for relatively minor changes in interest rates." In other words, Duration is essentially how much money something will make you or cost you. Duration Matching is the matching of one (cost) with one (money-maker).


Insurance companies use this technique to "level" their assets and liabilities. For example, a five-year $100k annuity may be sold by an insurance company or annuity carrier. At the same time, a 5-year bond is purchased to match the annuity.


Rates are Set Depending on the Type of Annuity and Duration

Melissa cox CFP explains how annuity rates are set

Insurance companies set the rates offered on their annuities based on a few factors when an annuity contract is purchased. For example, interest rates will vary based on the type of annuity purchased, the assumed investment duration, and bonds available for purchase by the insurance company.


The examples I'm providing below provide a basic peek under the hood of annuities. Understanding the concept behind an annuity and how it works is essential. Much like most modern cars, when you open the hood, there are still parts and processes that go deeper into the inner workings. It would be impossible to cover every wire under the hood!


***In the Examples below, we are purchasing a 5-year Annuity with a $100,000 Premium. The rates quoted are based on an average of current interest rates offered by various insurance carriers.


Fixed-Rate Annuities


Fixed Annuities are the easiest to explain because they are pretty basic and are generally the chassis that most fixed or fixed indexed annuities are built on. Typically, the contract rate is set based on the bond the insurance company purchases to match the annuity duration. For example, with a 5-year $100,000 Fixed annuity, the insurance carrier can purchase a 5-year AA Rated Corporate Bond with a Yield to Maturity of 3.75%. In turn, they will typically keep a percentage of the interest rate and credit 3.35% to the annuity holder.


Fixed Indexed Annuity


Much like the fixed annuity above, the insurance carrier will purchase an underlying bond to "guarantee" the return of principle. However, these bonds are often purchased at a discount to par, meaning the whole $100k is not spent purchasing the bond. Instead, the insurance company takes the remaining principle and invests it for growth.


Fixed indexed annuities are credited based on the interest crediting option selected by the contract purchaser. Crediting options add a whole other level of complexity and should be discussed with your financial professional. In this example, I'm basing the interest crediting rate on a 6.5% cap point to point based on the S&P Index. Point to point generally means the carrier picks a specified day (usually your contract anniversary) and credits your contract based on what the annuity has done based on the 1st day and last day of the contract year.


For Example: Your contract is credited up to 6.5% depending on the returns of the S&P 500 Index; 

  • Index Return : 6% = Credited 6%
  • Index Return : 2% = Credited 2%
  • Index Return : (-4%) = Credited 0%
  • Index Return : 13% = Credited 6.5%


Variable Annuities


Variable annuities are an entirely different game! They are the riskiest of the annuities because their underlying investments are not strictly bonds like fixed contracts. Investors risk losing money in variable contracts because a portion of their accounts is invested in sub-accounts containing mutual funds or other investment products. A guarantee with a variable contract typically comes in the form of a rider and will cost a pretty penny in fees.


How Annuity Returns Compare to the S&P Market Returns


Melissa cox CFP compares annuity returns with the S&P 500

As I've already stated, annuities are highly popular when the markets are in turmoil. However, it's not easy or comfortable to watch your portfolio's value decline. The true question at hand is how do annuity returns compare to the historical returns of a market such as the S&P. Before I answer, I want to remind you that past performance is never an indication or guarantee of future performance.

Comparing Indexed Annuities to the S&P is also not an apples-to-apples comparison. For starters, annuity companies update their products regularly with bigger and better options. Over the last decade, we have also been in a reasonably flat interest rate environment, which puts a damper on the underlying bond yields. On top of this, I'm also not considering any fees which could further erode your earnings!



S&P ReturnsFixed Annuity - 3.53%Fixed Indexed - 6.5% Point to Point S&P 500 Index  Fixed Annuity  Fixed Indexed Annuity - 6.5% Point to Point
2002-23.37%3.53%0.00% $      76,630.00 $  103,530.00 $   100,000.00
200326.38%3.53%6.50% $      96,844.99 $  107,184.61 $   106,500.00
20048.99%3.53%6.50% $    105,551.36 $  110,968.23 $   113,422.50
20053.00%3.53%3.00% $    108,717.90 $  114,885.40 $   116,825.18
200613.62%3.53%6.50% $    123,525.28 $  118,940.86 $   124,418.81
20073.53%3.53%3.53% $    127,885.72 $  123,139.47 $   128,810.80
2008-38.49%3.53%0.00% $      78,662.51 $  127,486.29 $   128,810.80
200923.45%3.53%6.50% $      97,108.86 $  131,986.56 $   137,183.50
201012.78%3.53%6.50% $    109,519.38 $  136,645.69 $   146,100.42
20110.00%3.53%0.00% $    109,519.38 $  141,469.28 $   146,100.42
201213.41%3.53%6.50% $    124,205.93 $  146,463.14 $   155,596.95
201329.60%3.53%6.50% $    160,970.88 $  151,633.29 $   165,710.75
201411.39%3.53%6.50% $    179,305.46 $  156,985.95 $   176,481.95
2015-0.73%3.53%0.00% $    177,996.53 $  162,527.55 $   176,481.95
20169.54%3.53%6.50% $    194,977.40 $  168,264.78 $   187,953.28
201719.42%3.53%6.50% $    232,842.01 $  174,204.52 $   200,170.24
2018-6.24%3.53%0.00% $    218,312.67 $  180,353.94 $   200,170.24
201928.88%3.53%6.50% $    281,361.37 $  186,720.44 $   213,181.31
202016.26%3.53%6.50% $    327,110.73 $  193,311.67 $   227,038.09
202126.89%3.53%6.50%Ending Value of $100k Investment $    415,070.81 $  200,135.57 $   241,795.57
Effective Average Growth Rate8.92%3.53%4.55%

Let's look at a hypothetical comparison between a fixed 3.53% Annuity, a Fixed Indexed Annuity with a 6.5% Point to Point S&P 500 Cap, and the actual S&P 500 Index since 2002. In the 20-year period, the average effective growth rate of the S&P is 8.92% versus 4.55% in the Fixed Indexed Annuity. With a net difference of $173,275.24 in favor of the S&P.  



For grins, we can take our hypothetical even further back to 1928. Since 1928 the S&P has had an effective growth rate of 7.98% through 2021. Indexed annuities did not exist until 1995, but if they had existed as they do today, the fixed indexed annuity with the 6.5% point-to-point crediting option would have only yielded 1.82%!


Why would I buy an annuity?

Melissa Cox CFP explains why purchase an annuity

After reading this, one might wonder why on Earth would you buy an annuity! Of course, the obvious answer is for the guarantee! I know what you are thinking! "Melissa… maybe you should go back and reread your own work". Admittedly, I have a love-hate relationship with annuities and those that sell them. Still, annuities can be beneficial in a comprehensive financial plan.


Learn about things to consider before purchasing an annuity

As a Certified Financial Planner, I help clients by weighing the pros and cons of using an annuity in their plan to meet their specific financial needs and goals. If you're interested in exploring options that will help you save and invest for retirement, please call or email to schedule an appointment with me.

Until next time...this is Melissa Making Cents!

Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.

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