Real World Index Annuity Returns Updated
The Wharton Financial Institutions Center from the prestigious Wharton School (of Business) at the University of Pennsylvania released a study last October entitled Real World Index Annuity Returns. We made the study available to you at that time. It has now been updated and expanded. This study provided the first empirical exploration of fixed indexed annuity returns based upon actual contracts that were sold and actual interest that was credited on those contracts. The study included the following findings, none of which should be surprising.
- FIA returns have been competitive with alternative portfolios of stocks and bonds.
- FIA design has limited the losses associated with declining markets.
- FIAs have achieved respectable returns even in more robust equity markets.
- Studies that have criticized FIAs are typically based on hypothesized crediting rate formulae, constant participation rates and caps, and unrealistic simulations of stock market and interest rate behavior. When actual policy data are used, the conclusions change.
The study concluded that from 1997 through 2007, for the contracts examined, five-year annualized returns for FIAs averaged 5.79%. These returns compare to 5.39% for taxable bond funds and 4.73% for traditional fixed annuities over the same period. The study also found that for the period from April 1996 through December 2008, a specific and typical FIA's returns bested the S&P 500 alone 66% of the time and a 50/50 mix of one-year Treasury Bills and the S&P 500 80% of the time.
Not surprisingly, the study finds that FIAs are particularly desirable for consumers who are especially concerned with avoiding losses because they are "designed in a way to avoid downside risk [and] they tend to produce preferred return patterns for such [risk-averse] consumers when compared to alternative investment strategies that expose consumers to significant levels of that risk."
The study's conclusions won't be a surprise to those familiar with FIAs. How will index annuities perform in the future? We do not know but the concept has proven to work in the past and any articles should reflect this. FIAs were not designed to be direct competitors of index investing nor have FIAs been promoted to provide returns to compete with equity mutual funds or ETFs. The FIA is designed for safety of principal with returns linked to upside market performance.
We already knew that an FIA can be a good product for nearly any consumer and that FIAs are particularly advantageous for risk-averse consumers. The Wharton Financial Institutions Center has provided a powerful tool—from a respected an unbiased authority—to support and substantiate what we already knew.
This groundbreaking Wharton study on FIA returns has now been updated with some additional helpful information. The updated study is linked here. I encourage you to use it routinely.
Real World Index Annuity Returns (revised edition)
Taxation of Annuity Income
The Obama administration has been saying that it wants to encourage annuity sales to ensure that retirees don’t outlive their money. However, actions speak louder than words, and the recent health care reform legislation suggests otherwise in that it puts a 3.8% tax on pay-outs from annuities purchased by higher income consumers outside their workplace.
To help pay for the $940 billion health care reform measure, the administration and congressional Democrats included a 3.8% Medicare payroll tax on single people who earn more than $200,000 a year and couples earning over $250,000 a year. Starting in 2013, the tax will be applied to annuity distributions, interest, dividends, capital gains, rents and royalties. Common sense would suggest that this tax will impede annuity sales. However, the administration claims that the tax won’t discourage people from choosing annuities. In a March 23 letter to the IRI, Michael Mundaca, acting assistant Treasury secretary for tax policy, said the tax is "not a proposal that is designed to or should discourage individuals from saving through purchasing annuities." The tax "does nothing to alter the favorable tax treatment of annuities inherent in deferring taxation of annuity earnings until annuity payments are made and then treating a portion of each payment as a return of the previously taxed funds used to purchase the annuity," he wrote.
Why is this an issue?
In a world where defined benefit plans are going the way of the dinosaur and Social Security benefits seem more at risk than ever, concern about retirees running out of money is extremely well placed. Experts who agree on little else agree that income annuities need to play a crucial role in retirement and that they are seriously underutilized. As noted by Prof. David Babbel of Wharton:
"I have reviewed over 70 academic studies that have appeared since 1999, analyzing lifetime income annuities vs. other alternatives, and coauthored another major study. (Most of these are included in the reference section to this paper, as well as a handful of earlier academic studies, each marked with an asterisk.) The consensus of the literature from professional economists is that lifetime income annuities should definitely play a substantial role in the retirement arrangements of most people. How great a role depends on a number of factors, but it is fair to say that for most people, lifetime income annuities should comprise from 40% to 80% of their retirement assets under current pricing. Generally speaking, if a person has no bequest motive, or is averse to high risk, the portion of wealth allocated to annuities should be at the higher end of this range.
"Lifetime income annuities may not be the perfect financial instrument for retirement, but when compared under the rigorous analytical apparatus of economic science to other available choices for retirement income, where risks and returns are carefully balanced, they dominate anything else for most situations. When supplemented with fixed income investments and equities, it is the best way we have now to provide for retirement. There is no other way to do this without spending much more money, or incurring a whole lot more risk&madsh;coupled with some very good luck." Lifetime Income for Women: A Financial Economist's Perspective.
As another Wharton study points out:
"[E]conomists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, among whom are Nobel Prize winners. Studies supporting this conclusion have been conducted at such heralded universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few. The value of annuities in retirement seems to be a rare area of consensus among economists." Investing your Lump Sum at Retirement (representative studies linked below).
On account of this problem, the federal government had previously said that it wanted to find ways to encourage people to invest at least part of their 401(k) and other similar retirement savings plan dollars in annuities when they retire, so they can be assured of a steady stream of income for the rest of their lives. The Treasury Department and the Department of Labor are both on the case. Treasury wants employers to add “automatic annuitization” to 401(k) plans. As currently conceived, this feature would require a portion of a worker’s lump sum 401(k) distribution made at retirement to be converted into an annuity unless he or she opts out.
However, offering an annuity option is a hassle for employers because of current pension regulations, so Treasury is considering easing those rules. Eventually, for example, the Department could clarify that an employer isn’t liable for lost retirement savings if an annuity provider goes belly-up. If easing various rules doesn’t encourage enough companies to adopt the feature, Treasury could consider requiring that it be added to plans.
U.S. Labor Secretary Hilda Solis outlined her top regulatory goals for 2010 in a webcast in January, and increasing public awareness about the need for annuities stood out in her remarks. “Increasingly, retirees will have to live on lump sum distributions from 401(k)-type plans,” Solis said. “This increases the likelihood that they will run out of assets during their retirement years. Our goal is to reduce the chance that workers will outlive their retirement by increasing public awareness of the need for annuities, and encourage employers to offer annuities as an option.”
Getting retirees to buy into the idea of income annuities has always been an uphill battle. Studies routinely show that workers typically prefer taking lump sum payouts of retirement savings and managing the funds themselves, even though they know there is no guarantee that they will be able to make the money last long enough and even though it isn't the best idea (as highlighted above). Only 2% of 401(k) plan participants convert retirement savings into an annuity on retirement, according to a July 2009 report from the Retirement Security Project, a joint venture of Georgetown University's Public Policy Institute and the Brookings Institution in Washington, and a survey of 149 companies released last December 17 by employee-benefits consultant Watson Wyatt Worldwide, now part of Arlington, Va.-based Towers Watson & Co., suggested that about 22% of employers with retirement savings plans offered retirees the choice between an annuity and a lump-sum distribution.
Experts say that one way around the reluctance of retirees to annuitize could be to allow trial annuities—putting some portion of the 401(k) distribution into an annuity that could be canceled after a set period of time, say one or two years. The thinking is that once account holders get used to that steady stream of income, they won’t bother unwinding the investment when they finally get the chance.
Not surprisingly, the securities industry is opposed to annuitization. According to a survey conducted by the Investment Company Institute, seven in 10 U.S. households would object to a requirement that retirees convert part of their savings into annuities. "Households' views on policy changes revealed a preference to preserve retirement account features and flexibility," the Institute said.
Governmental efforts at increasing the use of annuities have been spearheaded by Mark Iwry of the Treasury and Phyllis Borzi of Labor. A paper by Iwry on the subject when he was at the Brookings Institution is available here. There is "a tremendous amount of interest in the White House" in retirement-security initiatives, said Borzi, who heads the Labor Department's Employee Benefits Security Administration. In addition to annuities, the inquiry will cover other approaches to guaranteeing income, including longevity insurance that would provide an income stream for retirees living beyond a certain age, she said.
Critics of the government's plan argue that bureaucracy should "stop meddling" in retirement accounts. Cynics also feared that the government is merely looking for a new revenue stream for financing its bloated spending initiatives in that it will lead to a requirement that retirees taking this option buy Treasury bills to ease deficit bills. Those cynics seem to be right, although not in the way they expected, as a consequence of the new tax initiative.
Several industry organizations are working to repeal this 3.8% tax. I encourage you to write to your representatives and make your views known.
Representative papers on the need for income annuities:
Rule 151A Update
As you are all aware, various industry groups have banded together to support the passage of the “Fixed Indexed Annuities and Insurance Products Classification Act” to clarify that FIAs continue to qualify for the Securities Act’s Section 3(a)(8) exemption and are not within the SEC’s jurisdiction. This bill has been introduced in the Senate by Senator Ben Nelson as S. 1389, and in the House by Representative Gregory Meeks as H.R. 2733. The legislation has strong bipartisan support, with over a dozen Senate sponsors, and over 70 in the House. I have been to Washington, D.C. on two separate occasions to urge the passage of this legislation.
Now that health care reform is in the rear view mirror (at least legislatively), industry experts hope that this initiative can get some real traction. Stay tuned, and make sure to keep this issue in front of your elected representatives.
Annuity Suitability Rules Expanded
The executive committee and plenary committee of the National Association of Insurance Commissioners voted to adopt an updated version of the annuity suitability rule this week at its spring meeting in Denver. New amendments to the NAIC’s annuity suitability model regulations will hold carriers responsible for ensuring that all annuity transactions are suitable for clients. Previously, the suitability rule only applied to variable annuities.
There are three basic additions to the rule. A regulatory framework was established that is aimed at holding carriers responsible for ensuring that all annuity transactions are suitable for clients. Thus they must now establish a system to supervise recommendations. The NAIC gave a list of factors going into the consideration for suitability, including the intended use of the annuity and the client’s existing assets, including investment and life insurance holdings.
A second addition to the model regulation is to require that producers receive training on the provisions of annuities and the products they sell. Producers who are currently insurance licensed and want to sell annuities must complete the course within six months of the effective date of the regulation.
Finally, the suitability standards—when feasible—now need to be consistent with those of the Financial Industry Regulatory Authority. FINRA doesn’t (yet? – see above) have regulatory authority over fixed annuities, including FIAs, but broker-dealers that choose to subject fixed annuity sales to FINRA standards of suitability and sales compliance would be meeting the NAIC’s requirements as well.