Annuities are contracts between individuals and insurance companies. Annuities are investments that also possess various insurance features. The purpose of insurance is to reduce risk. Thus, the association of annuity investment with risk may seem anomalous. In fact, risk is omnipresent and unavoidable in investment. The nature and type of the legitimate risks associated with annuity investment should be known to every potential buyer of annuities.
The immediate picture that the words “investment risk” bring to mind is of a particular company going bankrupt with its stock, formerly worth many dollars, now worth nothing or mere pennies. Mutual funds were created to reduce these kinds of risks through diversification, yet a truly cataclysmic market decline could vaporize half of a fund’s market value. In a garden-variety recession, negative returns of 10% are not uncommon. These kinds of investment losses are the loss of principal value, which is what most people think of as investment risk.
Although annuities pose a very minimal risk to principal, their risks are more subtle and varied.
Liquidity risk is the risk that the investor will be unable to translate the value in the investment into immediate access to goods and services; i.e., he or she will be unable to exchange the investment for cash on short notice.
Annuities are long-term, retirement-oriented investments. Withdrawals by individuals younger than age 59 ½ face 10% tax penalties levied by the IRS. Early withdrawals confront surrender charges imposed by the issuing insurance companies. The charges vary in magnitude and duration, from 1-10% for 3-10 years. (Withdrawals in the first year are penalized much more than those in subsequent years.) Most annuities make limited provision for liquidity, allowing up to 10% or a year’s worth of accrued interest earnings in annual withdrawals. Many annuities include provisions to waive surrender charges in special contingencies or emergencies, such as extreme financial need or health emergency. Nonetheless, the prudent course is to invest only long-term money in annuities.
The newest variable annuities offer guarantees of minimum lifetime withdrawals and income. To the degree that these features reduce liquidity risk, they may do so at the expense of increasing company risk (see below).
Arguably, this is simply a global variety of liquidity risk. Still, its importance justifies a separate discussion. Along with tax deferral, the central appeal of the annuity is the bedrock security attained by guaranteeing an income for life. This is done by surrendering a large capital sum, perhaps comprising all or most of the investor’s net worth, to the insurance company. Once the decision to annuitize is made, the company controls this money. This applies even in a variable annuity, in which the investor controls the investment process.
Annuitization is a highly significant step. The loss of control it implies is undoubtedly the reason why annuities do not enjoy even greater popularity with the general public. Once again, recent variable annuity products have sought to soften the blow of annuitization through delaying and attenuating the decision-making window.
Annuitization risk is not financial as much as psychological. The loss involved is not a depletion of principal but rather the opportunity cost of foregoing a vacation or big-ticket purchase that liquid assets could have financed. Of course, this psychological loss could take financial form if, say, the investor decided to cash out the annuity at a loss by visiting one of the firms that specialize in these transactions.
One of the major advantages of annuity investment is tax deferral, the privilege of enjoying tax-free accumulation and compounding of the investment. The other side of this coin is that when the annuity proceeds are distributed, investment gains become taxable. Each annuity distribution payment will consist partly of return-of-principal (not taxable) and part investment gain (taxable). The same insurance status that gave annuities their tax deferral also makes their investment gains taxable as ordinary income rather than as capital gains. That difference is quite significant, since capital gains are currently taxed at 15%, while income-tax rates range from 10% to 35%. Depending on individual circumstances, the necessity of paying income taxes rather than capital gains taxes at distribution may wash away the gains from tax deferral.
The investment vehicles of variable annuities and mutual funds are nearly indistinguishable, while variable annuity investment is tax-deferred. This may seem to make the variable annuity the obvious choice. Although mutual fund investment is not tax-deferred (unless conducted within a qualified plan), mutual fund liquidations are taxed at capital-gains rates. This may be enough to tip the balance in favor of the mutual fund.
Once again, this might easily have been subsumed in the category of tax risk. The taxes owed upon distribution of the annuity are not cancelled by death. If the annuity distribution generates taxable income to the holder, the income is also taxable if the privilege of annuitization is assumed by one or more heirs.
Many financial assets, such as stocks, mutual funds and real estate, enjoy the privilege of a step-up in basis to a date-of-death valuation. That is, once their owner dies, the inheritor(s) of the asset can calculate their cost basis in the asset by using its value on the day its original owner died, rather than its original acquisition cost. This cancels out the taxes owed by the original owner – a valuable benefit. Annuities get no step-up in cost basis, which makes them less attractive as vehicles for building an estate.
One measure retired annuity holders might take to preserve the value of their legacy is to spend down the value of their annuity holdings relative to other assets, thereby minimizing the tax losses suffered by their heirs. Once annuitization has begun, the spending die is cast, so this strategy demands foresight by the investor.
Interest-rate risk is the risk that market interest rates will change, leaving the investor stuck with a disadvantageous rate. The clearest example involves CD annuities, in which the credited interest rate is guaranteed for the term of the investment, which ranges from 1-10 years. A danger of locking in a long-term investment yield is that a higher market yield may become available during the guarantee period, leaving the investor with the choice of paying a liquidity penalty for escaping from the CD annuity or accepting the lower rate. Interest-rate risk is endemic to fixed-income investing, as (for example) holders of bank CDs are well aware.
Ironically, CD annuities are a response to criticism of traditional fixed annuities, which often guarantee the initial credited interest rate for as little as one year, after which the interest rate may change from year to year in accordance with market conditions. Having whacked one mole with the CD annuity, insurance companies face another in the form of interest-rate risk.
Insurance Company Risk
The annuity-payout guarantee and insurance features of the annuity contract are underwritten by the financial strength of the issuing insurance company. Before signing the annuity contract, the investor must investigate the insurance company and ascertain its soundness. At least four major rating agencies evaluate life-insurance companies and publish the results.
The level of risk undertaken by the annuity investor is not comparable to that associated with an equivalent equity investment in a single firm. Insurance companies employ experts in investment and hold large, diversified portfolios of assets. In addition, some additional security is provided by state guarantee funds, in which the state’s insurance companies pool funds to indemnify investors of bankrupt insurance companies.
Inflation, a rise in the general level of prices, represents a fall in the purchasing power of money. Inflation risk is the risk that inflation will decrease or wipe out the investor’s real rate of return by eating away at the purchasing power of the nominal units in which the investment is denominated. Inflation is particularly fearsome to holders of fixed-income assets, who are unable to increase their fixed income payments but must helplessly watch the purchasing power of each unit of income decrease day-by-day. Immediate annuities and fixed annuities (including CD annuities), which are most like fixed-income securities in their risk/return properties, are highly susceptible to this risk.
At one time, economists encouraged investors to hold stocks as a prophylactic against inflation risk. Their thinking was that stock prices would rise in tandem with inflation, increasing investors’ wealth even as the purchasing power of their income fell. The decade of the 1970s disillusioned both economists and the investors who followed this advice. The most insidious feature of inflation is that all prices (as well as incomes) do not rise in tandem. The random nature of changes in relative prices wreaks havoc in equity markets (just as it did in the U.S. stock market during that decade) because investors cannot accurately judge the true performance of one firm relative to another. Consequently, variable annuities and indexed annuities, which offer equity-market participation to their holders, are no necessary solution to the problem of inflation risk.
Although financial markets have experimented with internal solutions (such as bonds with interest rates tied to some index of inflation such as the Consumer Price Index), none has yet been found. Inflation risk is really a political problem. In the words of the great economist Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.” When central banks increase the quantity of money sufficiently to make inflation a problem, their purposes are political. Investors, as such, cannot cure this ailment; all they can do is remain alert for symptoms and treat their portfolios accordingly.
In one sense, market risk is the risk that annuities were created to insure against. Were it not for this type of uncertainty, the security of guaranteed lifelong income would not be so highly prized. Many of the insurance elements in annuity contracts, such as guaranteed minimum credited interest rates or accumulated values, were designed to offset this risk.
Variable annuities and indexed annuities are investment products whose credited returns vary in accord with market fluctuations. Thus, market risk affects them, albeit in a sharply moderated way. These products also contain features designed to build a floor under credited interest, income and withdrawals. Consequently, they are not fully exposed to market risk.
It is also worth noting that the market risk felt by variable and fixed annuities is systematic risk, which cannot be diversified away. The diversification of variable-annuity subaccounts and broad general indexes diversifies away unsystematic risk. Modern portfolio theory recognizes this as an important benefit of annuity investment.
The inherent or optional insurance features of annuities may seem to make them unlikely candidates for investment risk. While the risks posed to principal investment value by annuities are low indeed, they are not zero. Much more important is the nature of annuity investment risk. It is not a bludgeon like the risk of bankruptcy that hangs over investors in particular stocks. Instead, it is as subtle as the loss of control associated with annuitization. The liquidity, tax and interest-rate risks of annuities are no less real for their comparatively understated character. Still, there is no doubt that annuities live up to their billing as a buffered form of investment vehicle – the sort we would expect insurance companies to provide. There is no other vehicle that fulfills the competing desires for wealth and security as well as annuity investment.