Chapter 4 — Investors & Objectives

While it is cliché to state that all clients are unique — and indeed all investors have unique needs and face different circumstances — annuity investors can be classified into four broad categories:

• Individual investors
• Trusts
• Charities
• Corporations

Over the course of a human lifetime, an individual’s investment objectives will typically pass through four phases: accumulation, conservation, distribution, and transfer. In one’s younger years, the focus is on accumulation of wealth — whether scraping together a down payment for a first home, making contributions to a retirement account, or setting aside funds for children’s college. As the investor ages, the objective shifts from appreciation to conservation — riskier investments that may result in significant gains give way to less-risky investments offering safety of principal. As working years end, the objective becomes how to ensure that accumulated and conserved wealth can support the investor in retirement. At the end of one’s life, the focus is how best to pass on one’s wealth to designated beneficiaries.

Let’s take a look at how annuities — fixed, variable, and indexed — can help individual investors achieve these objectives.

Historically, equity investments offer the greatest possibility of capital appreciation. The term “equity,” meaning ownership, encompasses a wide range of investments — owning a small business, owning real estate or other tangible assets, or participating in the ownership of large corporations through the purchase of common stock. Equities have tremendous upside potential, but also significant risk. Investment advisors must take into account an investor’s tolerance for risk in meeting the objective of capital accumulation. Rather than simply investing in vehicles that offer the possibility of capital appreciation, investors should invest in a manner that maximizes the probability of achieving his or her goals. This may entail investing in a range of riskier and less risky assets — the underlying principle of Modern Portfolio Theory.

In the annuity market, investors seeking capital appreciation have two options: variable annuities and equity indexed contracts. Each offers different advantages and disadvantages to investors.

Variable Annuities

As discussed in earlier chapters, the investment performance of a variable annuity relies on the investments held in a variety of separate accounts. The contractholder selects which subaccount(s) to invest in, and the value fluctuates based on the current values of the investments held within the subaccount. Typically, the subaccounts invest in common stocks, with the expectation that common stocks offer better inflation protection — but as with any equity investment, there are no guarantees. The contractholder assumes the investment risk in a variable annuity.

Modern Portfolio Theory holds that the best way to achieve the highest possible returns with the least possible risk is to invest in a broadly diversified portfolio that can be rebalanced periodically in response to changing market conditions, preferably with little or no transaction costs. Variable annuity separate accounts (or a combination of subaccounts) offer the investor a way to create a broadly diversified portfolio. Most variable annuities today offer a wide range of subaccounts — each a professionally managed portfolio. Some are actively managed; others are passively managed. All of these investment alternatives come at an expense. Almost all variable annuity contracts also offer a “fixed subaccount” with a low guaranteed rate of return, which acts much like a fixed annuity within the variable annuity contract — and this fixed option comes without any management fees.

Modern Portfolio Theory calls for an investor to hold a efficient portfolio — a broadly diversified combination of weakly correlated securities that do not behave in lockstep. Advisors can use separate accounts with different investment policies as a “proxy” for an asset class (e.g., a subaccount investing in cyclical stocks combined with one holding countercyclical stocks).

Actively managed portfolios attempt to outperform the market. Advisors relying on Modern Portfolio Theory to construct an efficient portfolio may want to explore passively managed portfolio options within the contract, as these are designed to mirror the performance of a market benchmark (such as the S&P 500) and are more likely to match a particular asset class. Passively managed subaccounts and Exchange Traded Fund (ETF) accounts also carry lower expense ratios than actively managed counterparts.

One important aspect of Modern Portfolio Theory is that an efficient portfolio should be rebalanced periodically. Variable annuities typically allow switching funds among subaccounts without cost. Given the tax-deferred nature of annuities, such switches are not taxable events (as they would be in a mutual fund family) — so variable annuities offer a very cost-efficient means to rebalance a portfolio. Many variable contracts offer to automatically rebalance an investor’s holdings on a regular schedule (annually, quarterly, etc.) at no additional charge.

A related feature offered by many contracts is a dollar cost averaging program. This allows an investor to invest a lump sum without fear of investing at the wrong time. The company accepts the full lump sum into the contract’s fixed account and periodically transfers a predetermined dollar amount into the selected variable subaccounts — purchasing more units when the unit price is low and fewer when prices are high. Mathematically, a dollar cost averaging program will buy units at a lower average cost than the average price of units over that period.

Indexed Annuities

Indexed annuities, in contrast to variable annuities, do not rely on separate subaccounts of investments. Instead, the annuity issuer guarantees a rate of return based on an equity index, subject to limitations stated in the contract. In the context of Modern Portfolio Theory, indexed annuities offer investors a passively managed alternative to the choices presented within variable annuity contracts.

An investor who selects a passively managed subaccount in a variable annuity that mirrors an equity index is subject to investment loss if the index falls. That is not true in the case of indexed annuities. The company issuing an indexed annuity does not actually hold a portfolio that is representative of the index — instead, the issuer purchases index options. This allows the company to participate in the upside in the market, but not to suffer losses if the market falls. (The contractholder bears the cost to purchase the options by accepting limitations on how much of the index’s gain will be credited to the contract. Equity indexed annuities are not a “free lunch” program.)

The key difference between a variable annuity and an indexed annuity, from the investor’s perspective, is that the investor in a variable annuity is subject to the full investment results, up or down (net of management fees), while investors in an indexed annuity will participate only in the upside of any index moves — but those gains are limited by contractual features such as participation rates, caps, spreads, resets, etc. In a way, indexed annuities straddle the investment objectives of accumulation and conservation, which no doubt accounts for their popularity across a wide range of investors.

The second investment objective most investors have is conservation. Accumulation is the process of acquiring capital; conservation is the process of keeping it. This is the natural consequence of the aging process. As the investor ages, the time available to recover investment losses diminishes, so the focus changes to retention of the capital that has been acquired. “Safety of principal” sums up this objective.

While poor investment performance is the most obvious reason for loss of capital, losses can also arise from taxes, insolvency of the institution holding the investment, or attacks by creditors. Annuities of all types can assist an investor in meeting the objective of conserving capital.

Fixed Annuities

Fixed annuities, which offer a guarantee of principal, are the most obvious choice for those seeking conservation. The investor’s principal is paid to the company, and the company invests those funds in its general assets. The company must pay the investor the guaranteed rate of return regardless of the investment results earned in the company’s general assets. In a fixed annuity, the company issuing the contract bears the investment risk and the investor’s principal is guaranteed.

As with all annuities, growth in the fixed annuity investor’s account is tax-deferred. In many other investments, such as stocks and mutual funds, periodic distributions of income are subject to taxation, and only the after-tax portion can be reinvested. In a tax-deferred annuity, all earnings are available for compounding. This is sometimes called “triple compounding” — the principal earns interest, the interest earns interest, and the portion that would have been payable to the taxman earns interest. Fixed annuities, during their accumulation periods, are very tax-efficient. (As we’ll see later, annuities may not be as tax efficient when proceeds are distributed during the annuity period.)

Advisors must be aware that insurance and annuity companies are not depository institutions in which accounts are federally insured. All states have “guarantee funds” to reimburse owners of life insurance policies and annuity contracts for losses resulting from an insurer’s insolvency. Florida’s Life and Health Guaranty Association provides coverage of up to $300,000 for life insurance death benefits ($100,000 cash value), and up to $250,000 in cash surrender and withdrawal values for deferred annuity contracts (but not variable annuity contracts). Florida law prohibits agents from referring to this protection in their sales presentations. Annuity contracts of all types, in Florida, are also provided special protections against creditor claims (discussed later in this chapter).

Indexed Annuities

Much of the foregoing discussion of fixed annuities applies equally to equity indexed annuities — from a purely regulatory perspective, indexed annuities are fixed annuities. Unlike traditional fixed annuities, indexed annuities offer the opportunity to participate (albeit partially) in the upside of market advances while protecting the investor from the downside. In that regard, equity indexed annuities have tremendous appeal to investors concerned with conservation of principal.

Variable Annuities

Variable annuities subject the investor to the possibility of investment losses due to poor investment performance. As the variable annuity investor’s objectives change from accumulation to conservation, the investor can switch from subaccounts that aggressively pursue capital growth to other, less risky subaccounts. Newer variable annuity contracts contain several risk management features the investor may choose (at an additional premium) to lessen the effects of a bear market:

• Guaranteed minimum accumulation benefit (GMAB)
• Guaranteed minimum income benefit (GMIB)
• Guaranteed minimum withdrawal benefit (GMWB)

Newer combination riders incorporating all three “living benefits” provide all of these assurances with greater flexibility. These riders were discussed in greater detail in Chapter 1.

Variable annuities also provide a minimum guaranteed death benefit, protecting the investor’s principal for the investor’s beneficiaries regardless of the investment experience in the subaccount. Enhanced death benefits can provide additional protection, for an additional fee.

Variable annuities grow tax-deferred. During the accumulation period, earnings in a variable annuity’s subaccount grow through “triple compounding” of interest — and as long as the principal remains in the contract, the tax deferral works to the advantage of investors seeking to conserve principal.

Regarding insolvency of the issuing company: investments within the separate account of a variable annuity are, as their name implies, separate from the general assets of the issuing company. The separate accounts are not subject to the claims of the issuing company’s general creditors — the assets are reserved exclusively for investors in that separate account. It is important to note that there is no legal mechanism such as a state Guaranty Fund to reimburse variable annuity holders, nor are variable annuities subject to the reserve requirements that apply to fixed annuities. Simply put, the only thing backing the investment in a variable annuity issued by a failed company is the portfolio held by the separate account(s) selected by the investor.

At some point in the investor’s lifetime, the investment objective will change from acquiring and conserving wealth to distributing it. Some assets are easier to liquidate than others — real estate and ownership interests in small businesses can be particularly difficult. Annuities, by their very nature, are designed to provide a stream of income. Annuities — fixed, indexed, or variable — are the only investment options that can be converted into income payments lasting a lifetime. The concept of an income that cannot be outlived has given comfort to many investors.

In addition to the possibility of annuity payments, annuity contracts may also be liquidated, in whole or in part, during the accumulation period. (Once the contract is annuitized, however, the contractholder loses this option.) Large withdrawals in the early years will most likely be subject to surrender charges, although most contracts allow penalty-free withdrawals up to 10% of the account’s value. In addition, withdrawals from deferred annuities prior to age 59½ face a 10% tax penalty. With those caveats, for investors concerned with distributing wealth during their lifetimes, annuities are an ideal investment.

Fixed Annuities

Fixed annuity payouts provide a guaranteed income stream, paying a fixed amount periodically. The size of the payout depends on the value in the account, the interest earned in the contract, and the projected actuarial length of the payout period. Fixed annuities are the only situation in which income is guaranteed for the length of the payout period (usually a lifetime), but the fixed payments are subject to purchasing power risk.

A few insurers offer contracts with a true cost of living adjustment tied to an external index of inflation (such as the Consumer Price Index, or CPI). Some insurers offer fixed contracts in which the annual payout is increased by some stated percentage, usually 1–3%. The initial annual payout for annuities containing an adjustment factor will be less than that of a level one — the greater the guaranteed annual increase, the greater this difference.

Variable Annuities

Variable annuity payments are not guaranteed — they fluctuate based on the investment experience of the selected separate accounts. The intent is that, over time, the payments will increase to offset the effects of inflation, but this is not guaranteed. For those concerned with inflation protection, the current choices are variable annuities (which may perform better or worse than the inflation rate) or inflation-adjusted fixed payouts.

Riders such as the minimum guaranteed withdrawal benefit (GMWB) and minimum guaranteed income benefit (GMIB) discussed in Chapter 1 could also allay fears over declining variable payouts. The GMIB links variable annuity payments to a guaranteed benefit base that is unaffected by losses within the annuity’s separate account(s) — though this comes at an additional cost and usually requires annuitization using payout factors less attractive than those available to contractholders who do not elect this benefit.

For investors in variable annuities who wish to have the guaranteed income of a fixed annuity, most variable contracts will offer that as an option. If a variable contract does not have that option, the investor can exchange the contract tax-free under Section 1035 for another contract that does offer a fixed (or inflation-adjusted) payout.

The final investment objective is to transfer one’s wealth to intended recipients as efficiently as possible. Annuities contain survivorship benefits that accomplish this goal. All contracts will contain a minimum death benefit payable if the contractholder dies prior to annuitization:

• In a fixed annuity, that amount is usually the value of the initial contribution to the contract plus interest credited. For indexed contracts, the death benefit will be based on the greater of the guaranteed minimum rate of interest or the equity-linked rate.
• In most variable annuity contracts, the guaranteed death benefit is the greater of the initial investment or the current value of the separate account on the date of death. Most contracts also waive any surrender charges upon death.

Many variable contracts today offer enhanced death benefits — sometimes a pure add-on at an additional premium, sometimes incorporated into the standard contract through a higher mortality charge. Typically the enhancement will ratchet up the value of the guarantee to reflect the separate account’s value on certain anniversary dates (“as of the 5th, 10th, 15th year”) or provide for the guaranteed death benefit to increase by a stated percentage (e.g., 5%) per year.

As a life insurance product, death benefits payable under the annuity pass “by contract” to the designated beneficiaries, bypassing the probate process. In many cases, the contract may allow the holder to choose to restrict when and how the beneficiary will receive the death benefit proceeds — the company may permit a periodic payout method on behalf of the beneficiary, or limit the amount released each year.

If the contract has been annuitized using a payout method other than a straight life payout, the remaining annuity payments will be paid to the beneficiary until the end of the annuity period — directly, without the cost and delays associated with probate.

In summary, annuities can be used to meet the various investment objectives of most individuals as they age — be it accumulation of wealth in the early years of one’s lifetime or the efficient distribution of those assets in later life (or upon death).