Annuity guarantees: How real are they?

With the stock market so volatile, it's nice to be able to invest with guarantees such as those of variable annuities. Financial planner Bob Stanley pointed out a recent Smart Money article entitled "For Retirees, Security Doesn't Come Cheap." The article claimed "Some variable annuities now have minimum guarantees of 5%, pretty attractive when compared to a less than 2% return for the Standard & Poor's 500-stock index year to date." I'll certainly put a chunk of my portfolio in a product that pays a guaranteed five percent, so here is the story of my quest and how real the guarantee actually was.

I contacted the author of that article, and she told me that Prudential had such a product and did point out to me something I already knew - "the guarantee isn't as straightforward as the 5% makes it seem." I don't mind complexity as long as it's real.

The Prudential product

I contacted Prudential for more details and they provided me with a brochure entitled: Destination Retirement Income. This variable annuity offered many guarantees and the two related to guaranteed returns were:

-- Five percent annual return of your lifetime income.
-- Double your lifetime income over a 12-year period, which translates to a 5.94 percent annualized return.

My colleague, Steve Vernon, wrote about a version of this double-your-money product.

I interviewed Bruce Ferris, Prudential's SVP of annuity sales, about this complex product. Initially, Ferris was very quick to point out that the guarantees above were not cash guarantees. Rather they were income guarantees. He was also very upfront about the fees with the product, noting they were roughly 3.50 percent annually, which happens to make most expensive mutual funds look cheap.

Ferris said the investor could pick the funds within the variable annuity with an allocation up to 80 percent stocks. He stated that if the stock market declined, then Prudential would sell some equities and buy fixed income in order to manage Prudential's risk. This, of course, means a systematic practice of selling stocks low and buying them back again high, which is the opposite of rebalancing.

Testing the guarantee

I went through the mechanics of the product with Ferris, and then examined the value of the 12-year double-your-money guarantee. I used a 60 year old male buying $100,000 product. At age 72, his value for income purposes would be guaranteed to be $200,000, entitling him to an "income" stream of five percent, or $10,000 annually. Of course this isn't really income, since a good chunk of it is actually just a return of his principal.

How valuable is this guarantee? According to the life expectancy tables, this 60 year old male will live to age 81 on average, thus collecting only $90,000 between age 72 and 81, which generates no income and only returns most of the principal.

Comparing guarantees

I'm not ready to write off the product yet, as it provides longevity insurance against outliving his money. So I looked at the alternative of this 60 year old male putting the $100,000 in safe CDs and then buying an immediate annuity at age 72.

It turns out that an immediate annuity purchased through Vanguard would pay 8.4 percent annually for the 72 year old male, or 3.4 percentage points more than the income guarantee being offered by Prudential. I calculated that the $100,000 put in CDs earning 2.75 percent annually (Pentagon Federal) would grow to $138,500 in 12 years. That amount of money would create a cash stream of $11,627 annually, or $1,627 more than under the Prudential product.

Prudential's response

Ferris noted that he owned this product and was very happy with it. He stated that this variable annuity had many upsides, such as locking in the highest daily value, and that it could provide much greater income than the guarantees. While true, the CD and immediate annuity strategy has significant upsides as well, since interest rates used to calculate the annual cash streams could go up significantly over the next 12 years.

My take

Planner Bob Stanley was spot on in noting that there was no such thing as a guaranteed five percent annual return annuity. If there were, I can assure you that Prudential and most other insurance companies would hold them in their own portfolio, instead of investment grade bonds paying far less.

The illusion being presented here is that Prudential doubles your value and then pays you out a cash stream at a captive rate far lower than you could buy in the open market.

I applaud Ferris for being so upfront about fees and the nature of the guarantees. I wish insurance agents would do the same with their clients. I also agree with him that this product does have upside beyond the guarantee. On the other hand, the 3.5% annual fees combined with systematic buying high and selling low, make it unlikely to be of much value.

My biggest disagreement with Ferris is with his statement that annuities are complex products because retirement income is complex. In reality, it would be very simple to say we guarantee a five percent annual return. Unfortunately, Prudential could perish if they did. In my opinion, the nature of the complexity is to provide illusions for agents to sell to consumers.

The next time you are reading a 200-page document describing a financial product, ask yourself if you think the attorneys and actuaries wrote it to protect you or the insurance company? Don't ever play a game you don't fully understand.