In Annuities, Better Rates Come With Complexity

By Conrad De Aenelle September 15, 2011

This article appears at the following website: nytimes.com

If you’re unhappy with the wretchedly low rates that many savings vehicles offer today, imagine how you would feel earning meager income until the day you die. If you recently began collecting on a fixed-rate annuity, you don’t need much imagination.

Rates on annuities — periodic payments for life by insurance companies to investors who have made regular or lump-sum contributions — are close to the lowest on record , just as bond and bank deposit rates are, financial planners point out.

At first glance, annuity rates do not seem so miserly. A woman, 65 and living in New York, for instance, can receive 7.1 percent a year, according to the Web site ImmediateAnnuities.com. That may sound like a decent amount, but the money used to finance an annuity is forfeited to the insurer, so much of the 7.1 percent amounts to a return of capital.

Investors looking for higher income, or at least the possibility of it, often turn to variable annuities, which invest in mutual funds and provide returns tied to those in financial markets. With stocks showing performance for the last decade that is modest or worse, and often volatile, variable annuities might have lost some appeal, planners say, so insurers have sold versions with enhancements like guaranteed minimum income rates or payments for nursing home stays.

Variable annuities, with or without these so-called riders, could meet the needs of some people in or near retirement, planners contend. They warn, however, that the vehicles tend to be complicated and expensive and may be best avoided.

Variable annuities “offer lots of good funds,” said Christopher Cordaro, chief investment officer of RegentAtlantic Capital in Chatham, N.J., “but they tend to be overloaded with fees and very opaque, so it’s difficult to pull them apart and figure out what you’re paying for.”

Much of the complexity and added cost stem from the riders. A typical income rider might offer the return on a stock index or a fixed percentage, typically 4 or 5 percent these days, whichever is greater — but with an asterisk.

When it comes time to draw income on some of these annuities, Mr. Cordaro cautioned, the amount that the investment would be worth under the guarantee cannot be cashed out or used to buy a fixed annuity at a market rate. It can only be converted to income at rates that would provide a total return, over the life of the annuity, below what would have been available through conventional annuities.

“You can get a stream of income, but not the pot of money they said this grew to be,” he said. “If you really do the math on these, the guarantees aren’t worth what you’re paying for them. Insurance companies tend to make a lot of money off these things.”

Not just on the fancy ones, either. The average bare-bones variable annuity has fees totaling 2.5 percentage points a year, according to Morningstar. (Payment rates quoted by insurance companies and specialist Web sites are net of fees and represent amounts paid to investors.)

John McCarthy at Morningstar says that, on average, 1.5 points of the fees are accounted for by the death benefit that the typical variable annuity calls for if death occurs in the period that contributions are being made. The other point covers the cost of managing the investment funds in the annuity.

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Other features mean additional charges. Todd Pack, president of Financial Advisers of America, a firm in Carlsbad, Calif., said that income riders cost 0.6 percentage points and up a year.

There are also annual charges for the bonuses that are often included to persuade investors to transfer from one annuity to another, Mr. Pack noted. He generally considers these bonuses a bad value, and he is no fan of nursing home riders, either.

“They tend to be very restrictive,” he observed. They kick in only after the annuity has been owned for several years, he said, or after the holder has been in a nursing home for many months.

Roman Ciosek, a managing director of HighTower, a Chicago financial advice firm, treats variable annuities with great circumspection, as his peers do, but he considers the rates available in some income riders attractive.

“Because rates are so low” on fixed-rate alternatives, “these annuities are more attractive,” Mr. Ciosek said. He added that he expected insurers to begin lowering rates in income riders, so he advised anyone interested in such an annuity to think about buying it sooner rather than later.

He suggested, however, that investors who would not need their money for at least several years might park it in a retirement account and buy term life insurance. That is a way to obtain the main features of a variable annuity at lower cost and with little added risk, in his view.

Mr. Cordaro recommended keeping a balanced portfolio of stocks and bonds and selling enough stocks each year to buy a no-frills, fixed-rate annuity with 5 percent of total assets. Each one should be with a different insurer because annuities are not federally insured and state authorities provide only limited protection for policyholders, he explained.

This gradual approach will also help avoid investment of a disproportionate amount during periods of very low rates. Because this is one such period, Mr. Cordaro would not be in a hurry to carry out his strategy. “If I knew that interest rates were going up in two or three years, which is probably a good bet,” he said, “I might want to hold off doing it.”