With protracted low interest rates, retirees have taken
extra risks to try to generate yield on their money. That means they are moving
it out of fixed-income securities and into equities, often without even
considering annuities as a potential higher yielding fixed-income substitute.
That was one of the key takeaways from a Wednesday afternoon
panel, led by David Lau, at the Next Chapter conference sponsored by Financial
Advisor. Lau is the founder and CEO of DPL Financial Partners in Louisville,
Ky., which works with RIAs and annuity providers to help match low-cost
annuities to clients' needs.
Lau’s panel discussion, called “The Role of Annuities in
Retirement Income Portfolios,” also included David Blanchett, PhD, a managing
director and head of retirement research at QMA, a quantitative equity and
multi-asset solutions specialist, and Bryan Montemurro, a financial advisor at
Two West Advisors in Overland Park, Kan.
Lau started by discussing the perceptions—or rather the
misperceptions—of annuities that persist today, including the ways they are
Montemurro added that he used to present the idea of
annuities to clients in a whisper, as if they were a dirty word.
That's no longer the case. A range of new products have
emerged that cost less and have less stringent surrender terms—meaning clients
don't get penalized as badly, or at all, for withdrawing funds early.
The Low Yield Environment
Blanchett noted that although annuity payout rates are
blunted by low interest rates, the lower rates actually make annuities a better
bargain than a regular portfolio. With annuities, you have the benefit of
mortality credits, sometimes called mortality pooling, which is a calculation
based on the annuitants’ life expectancy. That calculation stays the same no
matter where interest rates are. Next to a bond portfolio today, Blanchett
said, you can actually generate more income from an annuity.
His analysis showed that, because of mortality credits,
annuities can generate income about 40% more efficiently than bonds today.
"That's a very meaningful benefit to client retirement
income," said Lau. But he added that some advisors are waiting till
interest rates rise—effectively trying to time the market, whereas they would
never try to time equity markets.
Most retirees fear outliving their assets, and another big
group fears market volatility. One of annuities' main purposes is providing
secure retirement income that can't be outlived. Montemurro said he often
explains to clients that they insure their most valuable assets, such as their
home, yet don't think about securing their source of retirement income, which
is what annuities do.
Lau added that many people think lifetime income guarantees
come from annuitizing; instead, they come from separate income riders. The
principal of the annuity can continue growing even while income is drawn off.
Lau referred to research showing that those who have secured
their essential retirement income were better able to remain calm during the
30% market selloff in March 2020, early in the Covid-19 pandemic. They knew
they were in less danger from the market collapse. Those who were depending on
equity markets for their essential spending, on the other hand, were more
likely to panic and had a harder time staying the course.
Montemurro said that when he explains to clients the
difference between essential and discretionary retirement spending, many seem
to understand. Discretionary spending can be used for charitable giving or
legacy planning, say, but essential spending is for maintaining a lifestyle.
"It's for keeping the lights on," he said with a chuckle.
Annuities For Accumulation
Blanchett and Lau discussed how annuities can also be used
for asset accumulation. Multiyear guaranteed annuities, for instance, today may
pay about 2.5%, Lau said, which makes them effectively as safe as a bond or
bank CD, but they have a much better yield and offer tax deferral.
Variable annuities, which invest in mutual-fund-like
subaccounts, may come with higher fees than identical mutual funds held outside
the vehicles. But within the annuity rapper, taxes are deferred until
withdrawals are taken. If you find a no-load or low-load annuity, the fees are
reasonable, and the tax deferral can make it a better investment than a mutual
fund purchased in the open market.
Lau stressed that a key reason annuities have become a
better bargain in recent years is that many of them are now sold
commission-free. That means the sales rep works for a fee only and is not
compensated for selling a product the client might not need. This, in turn, has
brought down annuities’ costs.
Lau asked whether advisors charge clients the same fee when
managing equity and fixed-income portfolios. Some charge more for equity
portfolios than fixed-income portfolios. But according to a survey of
participants, most don't differentiate that way. They bill for assets under
management, no matter where or how those assets are invested. Blanchett added
that this makes sense, since the advisor does the same amount of work either
Letting clients know about the advantages of annuities
shouldn't cost advisors anything. Nevertheless, many still recommend a total
return portfolio that depends on 4% annual withdrawals to generate retirement
income, Lau said. This leaves clients open to anxiety over market
fluctuations—something annuities can help resolve.
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