Annuity Holders Pick Up The Tab

Annuities are, at their most basic level, promises. Companies want to have a reputation for keeping their promises; to act otherwise is bad business.

On the other hand, if their promises are complicated enough, companies can leave themselves quite a bit of room to maneuver while still technically keeping their word – as some variable annuity holders are discovering, to their detriment.

Variable annuities are contracts between annuity holders and insurance companies. The insurer agrees to make periodic payments to the annuity holder beginning at a certain date. Meanwhile, the annuity holder can select from an array of investment options, whose performance will affect the annuity’s ultimate value. (In contrast, a fixed annuity pays out at a predetermined interest rate, regardless of investment performance.)

In the years leading up to the financial collapse of 2008, variable annuities with guaranteed living benefit riders became very popular – nearly 90 percent of variable annuities had some form of guaranteed lifetime benefit that year. The rider is a feature an annuitant can purchase in addition to the annuity; it guarantees either a minimum return or a minimum lifetime monthly withdrawal. The feature was sold as a “seatbelt” of sorts, making the variable annuity safer and encouraging the investor to take more risks.

In the aftermath of the Great Recession, many annuity owners remain happy with their policies, but insurance companies have been less pleased.

The guarantees offered by the companies have become tougher to meet because of the lingering low interest rate environment, and because the costs to hedge annuity guarantees have increased. Some companies have gotten out of the business of offering new variable annuities with living benefit riders altogether, but they still have to address the existing contracts they issued prior to 2008.

Some sellers, most notably The Hartford and AXA Equitable, are now trying to wriggle out of various guarantees they made in contracts that were sold before the financial crisis. AXA announced this spring that it would change its investment lineup, ostensibly to offer “better” fund options. In reality, many of these funds were simply more conservative than the original funds AXA offered, forcing annuity holders to scale back their volatility whether or not they wished to do so. It is also offering annuity holders a lump sum to give up the guaranteed benefit rider.

Meanwhile, the Hartford has gone farther. It recently announced changes to its own investment offerings, which are even more severe that AXA’s. Hartford is also requiring policy holders to “voluntarily” change their asset allocations by Oct. 4 or else lose some of their previously guaranteed benefits. While these changes do not affect all annuity owners, an estimated 60,000 will see at least some difference in their annuity as a result.

These steps are legal. In all known cases, the companies are acting in ways that were authorized by language in the contracts – though of course buyers were seldom told about such escape clauses when they originally purchased the annuities. Annuity contracts can often stretch to hundreds of pages, making it unlikely that customers will read them closely or retain all that they did read.

We at Palisades Hudson don’t sell variable annuities. (We don’t sell any financial products at all.) Generally speaking, we don’t like them. Variable annuities offer only a limited range of investment options, and those which are offered are often tilted toward the insurer’s own products. The investments they offer are typically significantly costlier than the vehicles we prefer, and annuity contracts carry steep surrender charges unless you hold them for a very long time.

The key selling point is the annuities’ tax deferral, but in many cases our clients already have significant tax-deferred alternatives at much lower cost, through IRAs and company retirement plans. As the Securities and Exchange Commission points out, most investors get greater advantages through other tax-deferred investment options. The tax deferral is also partly offset by the fact that when the deferred income ultimately is paid, it is taxed at ordinary rates, rather than at the lower capital gains rates. Much of the remaining benefit of tax deferral is typically offset by the annuities’ higher annual costs in the form of mortality and expense charges, administrative charges and higher operating costs of the offered investment funds.

The other major benefits of variable annuity contracts are in the companies’ guarantees. Like any insurance company contract, these promises are ultimately worth no more than the company that makes them. Insurers will let you convert your policy’s investment account to a lifetime stream of income, which eliminates the risk of outliving your money (assuming the company makes good). They will also guarantee a minimum level of payout if you die at a relatively young age, which is essentially a form of life insurance, and they will often guarantee a certain level of income even if your investments do not perform well enough to pay for that cash stream.

In the heyday of variable annuity contracts, the belief was that, in the long term, such guarantees would not burden insurance companies. This was accepted for several reasons. First, long-term investors generally do pretty well, and the guarantees were relatively modest; it was likely the policyholders’ own money would support the promised benefits. Second, some annuity holders always opt to surrender their contracts early, paying the steep penalty charges to do so. This creates a windfall that the insurer can use to pay long-term holders. Third, the insurers knew they could invest the money collected in various policy fees to earn interest or capital gains. They could also buy hedges in the financial markets to help cover the guarantees.

But the financial crisis and the ensuing financial repression regime changed all that. The guaranteed living benefit riders became more valuable after stock prices were hammered and interest rates plunged. Hedges became much more expensive, and the interest that companies could earn became almost negligible. As I recently wrote in this space, extreme low interest rates are toxic to insurers.

Insurers were careful to draft plenty of wiggle room in their annuity contracts. Now they are wiggling like a striped bass in a Boston Whaler. Annuity holders need to be vigilant for any “offers” or notices the companies make; as The New York Times recently noted, it may not always be clear that such communications are urgent without careful reading. Annuity holders should be especially careful in deciding how to respond.

These days, a variable annuity is basically a zero-sum game: If a decision you make is good for the insurance company, it’s probably bad for you. Insurance companies are hoping annuity holders will decide in the company’s favor, and are stacking the deck as best they legally can to make sure of it.

About Larry M. Elkin 553 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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