22 September 2021

Clients Are Overlooking Annuities For Retirement Income, Panelists Say

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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.

Annuity Perceptions 

Lau started by discussing the perceptions—or rather the misperceptions—of annuities that persist today, including the ways they are overlooked.

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.

Retiree Fears 

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.

Fixed-Income Billing 

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 way.

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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