Case Study: Annuities and Volatility

Two years ago the S&P 500 hit an all-time high, just shy of 3000 points in the fall of 2018.  It was a level that seemed almost unthinkable.  Bulls were arrogant and bears were skeptical or maybe just jealous because they missed out on the rally.  By the end of the year sentiments had switched because the market lost more than 15% to bring things back to reality.

I met Neil right around the time when the market topped out.  He had sold a business and wanted to put some of the funds in a safe place and draw cash flow for a few years.   As soon as his wife could collect social security he wouldn’t need to draw near as much from his assets so all he needed was a short-term solution.

This is the case with lots and lots of people.  Early retirement, delayed pensions or trying to maximize social security require much more cash flow in early years than later.  This makes the traditional approach with income annuities irrelevant and the solution is quite simple, even if most people don’t use it.

Neil was also talking to a person who thought he should use a variable with all the fixings so he could have lifetime income and market participation forever.  With the fees being around 3.5% and Neil’s aversion to market risk I thought it was right to give him another option that was safer.

The numbers are what is important in this case. Neil wanted to set aside $400K and needed to draw $3000 monthly for the first two or three years.  It’s a really aggressive withdrawal rate of 9% and I don’t recommend anyone banking on that for the long run, no matter what type of luck you have with investments.  But for a short term deal it works just fine and I have many clients who are on an accelerated withdrawal plan for a few years at a time.

The variable annuity would have been really risky.  The income guarantee in the contract would not meet his short-term spending goals so additional withdrawals would be needed.  Taking extra money from a guaranteed income contract is possible but it waters down the income benefit and defeats the purpose of paying the fee.

My instinct was to avoid fees entirely, protect the money, withdraw what was needed and make sure the contract had adequate growth potential to replenish the basis as much as possible.  Needless to say we looked at a lot of numbers and he went with my approach.  Here we are two years later so I thought an update would be worthwhile.

Neil has pulled $72K from his annuity contract and at anniversary his account still had roughly $378K left.  When cash flow is accounted for, the internal rate of return for this investment is more than 6.5% average over two years.  Safety, liquidity and growth potential.  But how would the variable annuity have done?

I like to look back in time and test past recommendations to see how my advice performs.  It helps me get closer and closer to appropriate recommendations for anyone in the future.  Well, including fees and market performance in a stellar two year period, the variable annuity would have had a remainder value of $389K.  I’m a little behind but my deal isn’t costing Neil 3.5% per year and it has no market risk.  And at the low point earlier this year, the VA would have been just under $300K at one point, which is enough to make anyone nervous.

If he would have avoided annuities altogether and used an asset manager to invest directly in the market he’d have $408K left.  It’s not bad but there are also fees and market risk.  Ken Fisher charges 1.25% or more for his smaller accounts so that’s the fee I used for those numbers since Ken says that he’s cheaper than everybody else.  I’m not sure that’s true but he gets away with saying it publicly.

It also took some terrific market performance for either market investment to compete.  I guess the lesson is that when the market does well, the annuity does well and when the market doesn’t do well the annuity decreases the volatility in your portfolio.

For the record, it doesn’t have to be all or nothing one way or another.  Neil has more money than what he put in the annuity.  You should all remember that I advocate balance.  Safety AND growth but if your safe assets have enhanced growth potential, then you do better in the long run.  Bonds can’t do it.  CDs and money market funds can’t do it.  Index annuities are clearly the best option.

For an asset that gets no love, I’d say it did pretty well to stay within sight of what a top manager might be able to do during an extended market rally.  I don’t know of any other safe asset that would have been in the ballpark.  Lots of people had this option a couple years ago and passed on it for one reason or another.  If you bought a different annuity I hope you did just as well or better.  If you didn’t buy an annuity I hope you got into the market and didn’t bail during rough times.

What does the future hold?  Well I believe that this market has been purely propped up by stimulus funds and I’ll bet we get more of that no matter who ends up being president.  When the CEO of Walmart suggests more stimulus is needed then you know he knows that sales would be sluggish without it.  Aside from a few hiccups here or there the market may well do just fine in the next year.  Of course it’s risky but you know who to call if you want a protected downside along with some of the upside.

Happy Thanksgiving to all…


Last Updated on August 14, 2023 by Bryan Anderson