Pros and Cons of Expert Annuity Advice

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Late last week someone emailed to ask for my take on an article about indexed annuities from John, the Vice President of Research at Morningstar.  Given the writer’s experience with financial markets, I was curious to see whether he’d give annuities a fair assessment.  But it turns out that he doesn’t know a whole lot about them or just didn’t feel like doing the research this time.  He should have paid me to write the article instead of having one of his interns do it.

The advice itself shows that John doesn’t like indexed annuities and he should have just said that.  It’s called confirmation bias and I have a feeling that nothing I could say would change his mind.  In reality we are talking about two different things and if you correct a few things in the article then it’s nothing more than an opinion piece.

I’m going to give you several quotes from the article and tell you what is correct and what is not correct.  You can take the true with the false and make up your own mind.  The result is that you should probably listen to guys like John sometimes and other times listen to people like me.

“Also known as fixed-index annuities, equity-indexed annuities, and registered index-linked annuities, these are insurance contracts that combine features of both bonds and equities.”

This is incorrect.  Registered index-linked annuities are an entirely different product that fall outside the scope everything I write about on a regular basis.  Also known as buffered index annuities, this product deserves an entirely separate article if not its very own website.  This is irrelevant to the question that inspired the Morningstar article.

“…these are insurance contracts that combine features of both bonds and equities. As with bonds, indexed annuities pay interest; as with equities, their payments increase as the stock market rises.”

This is correct.  It is a balanced asset with elements of both safety and growth.

“Although the returns of indexed annuities are linked to the stock market, they are constrained. For example, an indexed annuity with a 10-year life might guarantee that, for each year in the contract, the investor will not lose more than 5% of principal no matter how poorly stocks perform.”

This is incorrect.  While the yield is constrained, a fixed index annuity CANNOT lose money.  When he mentions the hypothetical 5% loss that applies only to registered index-linked annuities.  That’s how they go the name buffered annuities; you can accept certain losses in exchange for higher cap and participation rates.  That’s why I don’t use buffered annuities.  Apples and oranges…

“However, in exchange for that protection, the issuer limits the investor’s gains. The annuity’s performance therefore moves in a narrower band than does the stock market.”

This is correct.  And I believe that’s the whole point anyway.  A mutual fund can go plus 20% or minus 20%.  A fixed index annuity can go zero and something like plus 10%.  It is a narrower band and that’s what people like about them.

John next brings up the SEC Investor Bulletin on indexed annuities which I’ve had a problem with and written about for years.  The SEC is not a credible source of information on fixed index annuities because they do not regulate the product and have nothing to do with implementation and oversight in this market.  Does anyone remember my test to become a Registered Investment Advisor a few years ago?  I had to answer a couple questions about annuities incorrectly to get them right on the test.

He gives us five points from the SEC and it should have been two points.  Three of them talk about pricing controls and two talk about protection from loss.  There’s not much interesting in the list except for the one below that brings up a good point.

  1. “Rate cap.–The annuity’s maximum annual payout. For example, if the annuity’s rate cap is 7% and its participation rate is 70%, then all stock-market appreciation above 10% would accrue to the insurer, not the policy owner.”

This is incorrect.  Yield above any cap or participation rate does not accrue to this insurer.  This is widely believed to be true because many consumers think that insurance companies are out to screw people.  The truth is that insurance companies use other financial institutions to run the options side of the contract.  Any profit over and above your cap or participation comes from additional options and accrues to the outside institution.  Curiously enough, Morningstar is one of those institutions that runs options on index annuities for a couple insurance companies.

The remainder of the article is more like an opinion piece and as mentioned before, it’s clear John doesn’t like index annuities of any kind.  Below is a quick list of the remaining arguable points.

“Indexed annuities differ sharply from index mutual funds.”

This is true and that’s the whole point, even if for different reasons than he feels important.

“Unfortunately, investors cannot research indexed annuities to determine which are the best values.”

This is true but mutual funds are anything but easy to research for the general public.  I pay for access to a database to research both mutual funds and annuities and you can too.  Information about stocks and mutual funds may be considered publicly available but you have to know what you’re doing to find the good stuff and even Morningstar charges a subscription fee to get the detailed information he says is readily available.

“In that respect, as well as several others, indexed annuities resemble their cousins, structured notes.”

This is not true.  Structured notes are a completely different animal.  There can be far more risk and far less liquidity depending on the option and it takes an incredible amount of expertise and you don’t get that for free.  If you wanted to build a structure note with the same amount of principal protection, liquidity and yield potential I doubt you’ll get one that’s got more upside than the average index annuity.

“The strength of those guarantees, of course, depends entirely on the creditworthiness of the issuer.”

This is true but there is no debate.  A highly rated insurance company is among the most stable financial institutions in the world and many have hundreds of years of consistency of making good on promises and guarantees.  If you want safety, strong insurance companies come first and there is no second place.

Index annuities are not the only asset, therefore should not be compared to every other asset.  It might make good ad copy to compare index annuities to mutual funds but it doesn’t make sense.  Those are two very different things.  If you are looking for maximum investment performance then you must accept the risk of losing money.  If you want to protect assets then you must accept a lower return.

There is a context for using annuities that is completely missed in the article.  If you are simply trying to compare assets to find which is better then you’ll find nothing but arguments from people who disagree.  No one is correct without defining a goal.  I can’t say that John is wrong because we are talking about two different things.  He needs to slightly adjust five or six sentences to make it factually correct and then it’s nothing more than just another opinion piece on index annuities.

If you disagree then go ahead and let me have it in the comment section below.

Bryan

7 replies
  1. Carl Stone&Frances Trustees Stone
    Carl Stone&Frances Trustees Stone says:

    Well put Bryan! I would never argue or disagree with the one known expert. You continue to be on the right track. Keep up the good work, and stay on top of the changes and keep us advised. Your the best! Hope all is well with you and your family. Is it more fun to hunt in the snow and cold? 🙂

    Reply
    • Bryan Anderson
      Bryan Anderson says:

      Hey Carl- all is well here in MT but winter isn’t over yet. It’s no fun to hunt in the snow but that season has been long over for a few months now. When September comes around it should be much better weather…

      Reply
  2. Barry Dang
    Barry Dang says:

    You continually provide great information and easy to understand analysis. Annuity products are the most misunderstood, and they are often unfairly categorized and editorialized by investment advisors.

    Reply
    • Bryan Anderson
      Bryan Anderson says:

      I agree Barry and try my best to be fair and a lot of it comes down to making sure we are all talking about the same thing.

      Reply
  3. Brian W.
    Brian W. says:

    Well done Bryan. It is always interesting to see how a “generalist” at a firm like Morningstar can be off the mark with commentary that is out of their area of expertise.

    Reply
  4. R.F. Segura
    R.F. Segura says:

    Bryan, good morning.
    Thank you for your honesty, and fact based analysis.
    My father in law’s, a retired attorney, favourite mantra was, “Read Between the Lines, and the clues / answers will be found!”
    It is refreshing to have a person such as yourself who is out presenting the truth, in the Best Interest of his clients, versus the few Black Sheep in the industry whose only self interest is which product pays a higher commission to them.
    Thank you once again.

    Reply

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