Anatomy Of An Annuity

10/5/2009


Dow Theory Forecasts focuses on providing profitable advice on stocks and mutual funds. But occasionally we discuss a topic that, while outside the stock market, is timely and relevant to subscribers’ pocketbooks. One such topic gaining investor interest is annuities.

According to insurance-industry group Limra International, the annuity market has grown by at least 50% in the past decade to more than $250 billion in sales. Much of that growth reflects demographics. An aging investor populace means an increased focus on reducing portfolio volatility, preserving wealth, and boosting cash flow. Annuity sales pitches aim squarely at those three objectives.

But do annuities make sense for most investors? The question has no simple answer. The term “annuity” covers a wide array of investment vehicles. For this article, the Forecasts focuses on perhaps the most straightforward, the immediate annuity.

Do-it-yourself pension plan

Immediate annuities work like this: In return for a single payment to the annuity provider (usually an insurance company), an individual receives a fixed, guaranteed monthly cash flow for life.

It’s important to note that with traditional immediate annuities, payments stop at death of the annuity holder. And the initial investment stays with the annuity seller. For example, if you buy an immediate annuity today and die a week from now, your heirs typically will not receive any payments.

The amount of an immediate annuity’s monthly cash flows will be influenced largely by the size of the investment, age, and interest rates. Let’s say a 65-year-old man purchases an immediate annuity for $200,000. According to ImmediateAnnuities.com, the man should expect to receive guaranteed monthly income of around $1,320 for the rest of his life. If he ponies up $500,000, the guaranteed monthly cash flow jumps to approximately $3,300.

The cash flow is not affected by stock market ups and downs. It’s not influenced by interest-rate movements. It is fixed for the life of the annuity owner.

The cash flows for the annuity discussed above reflect an annual distribution of nearly 8% of the original investment. How can the insurance company pay such a high distribution rate?

Because insurance companies pool funds from many annuity holders — and because payments to annuity holders are life-contingent — a portion of the assets contributed by those who die early finance higher payments to those who live longer. This pooling of assets and risks enables annuity sellers to pay interest rates higher than the risk-free rate of a Treasury security.

Another reason for the high cash flows is that part of the monthly payment represents a return of investment. Since return of investment is not taxable, annuity owners pay taxes on only part of the cash flow. The “exclusion rate” changes every year based on the investor’s age.

Defensive appeal

In light of the market debacle of 2008 and the historically high rate of dividend cuts in the last 18 months, it’s easy to see why investors are showing more interest in immediate annuities. For investors who desire more certainty and less volatility, immediate annuities make sense for at least part of their retirement investments.

But some features of immediate annuities may reduce their appeal:

The lack of flow-through to heirs can be a major turn-off. Some immediate annuities will make ongoing payments to beneficiaries, but the annuity buyer must be willing to accept lower monthly cash payments.

Loss of control and access to the money. If you need a chunk of funds to meet a sudden financial obligation, the annuity will not provide liquidity.

Large opportunity costs. While the fixed payments of immediate annuities look good in light of the market’s decline last year, the stock market is up some 50% since March of this year. A holder of an immediate annuity will not benefit from that increase.

Not all guarantees are created equal. Annuity cash flows are guaranteed by the insurance company writing the annuity contract, not the government. The guarantee is only as good as the survivability of the insurer.

Should an insurance company become insolvent, “State Guaranty Funds” are set up to help protect annuity holders. However, there are many issues that can influence the extent of coverage. For further information about state guaranty funds, contact the National Organization of Life and Health Insurance Guaranty Associations
(www.nolhga.com).

Investors should check out the health of annuity companies by comparing ratings from the four independent rating agencies — Standard & Poor’s, Moody’s, A.M. Best, and Fitch. Investors should also consider diversifying investments across multiple providers. The top seller of immediate annuities is New York Life.

Because prevailing interest rates partly influence the size of annuity cash flows — and current rates are very low — it may make sense to “ladder” annuity investments, spreading out your purchases over time.

To check out different immediate annuities, visit ImmediateAnnuities.com. In addition to insurance companies, most major brokerage firms and many mutual-fund families sell immediate annuities to investors, though an insurance company usually backs the annuity.


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