Morningstar Magazine - June/July 2018 - 13

Dispatches

Why Buy Annuities?
An image problem
obscures
their advantages.

IVORY TOWERS

John Rekenthaler

Ask Morningstar's retirement-methodology team
about annuities, and they will offer lavish
praise. When they model investment strategies for
retirees, they invariably end up recommending
big dollops of annuities for those who need
lifetime income. The reason, as Morningstar's Paul
Kaplan states, is that "self-created longevity
insurance is very expensive." Retirees who want
guaranteed income-and most do-are best
served through a pooled holding.
That theoretical attractiveness hasn't translated
to the marketplace. Last year, reports the
trade publication Ignites, annuities recorded $204
billion of new sales. In contrast, several trillion
dollars flowed into mutual funds and exchangetraded funds. (Net sales were $700 billion,
but gross sales-which is how annuity purchases
are measured-were several times higher.)
If the investment market were a meal, annuities
would be a shrimp cocktail.
First Impressions

Their first problem is their label. Nationwide
informs me that there are four types of annuities:
1) variable, 2) immediate, 3) fixed, and 4) fixed
indexed.1 Say what? The average American would
be likelier to spell "eudaemonic" correctly
than to define each of those four terms. (Perhaps
the average investment columnist as well;

I did not know what a fixed-indexed annuity was
before reading Nationwide's piece.) What's
more, not only do these four investments confuse
potential buyers by sharing the same name,
it's a nonintuitive name at that. A bond makes
sense. Ditto a fund. An annuity...sounds like an
actuary's task.

rule, when financial products are permitted
to bury costs, rather than state them explicitly, they
do not come for cheap. When the SEC warned
investors a few years back about the risks of
structured notes-another financial offering that
doesn't have expense ratios-it also cautioned
that such notes tended to be "expensive."3

My suggestion: Switch from "annuity" (a term that
only an actuary could love) to "guaranteed
income." The latter label lists the two reasons that
a retiree would have to buy an annuity. The
first is for the guarantee. As stated above, these
are insurance payments. The second, of
course, is for the income. People might not know
that they seek an annuity, but they certainly
will recognize that they desire guaranteed income.
Give the public what it wants.

Annuities could change that, if they wished,
by calculating and publishing their expense ratios.
The process would be trickier than doing
so for a fund, because the assets used to pay an
annuity wouldn't necessarily be segregated,
but the task could be accomplished by allocation.
The annuity provider, after all, would know
precisely its total costs and precisely its total
financial obligations. Thus, at the least, it
could publish an average expense ratio for its
entire book of business.

Rebranding annuities as guaranteed-income
vehicles makes them sound more appealing but
does not address the confusion that arises
from having multiple varieties of the investment.
(In addition to Nationwide's four groupings, there
are options such as inflation-adjusted disbursements or selecting various time periods
over which to defer the payments.) I don't have
an answer for that difficulty, but the right
marketing experts should be able to come up
with something.
Name That Price!

An even-larger concern is cost. A mutual fund or
exchange-traded-fund investor knows exactly how
much the management company charges, as
the company is required to calculate and publish
its expense ratio. The annuity buyer operates
in a fog. Most annuities do not carry expense
ratios.2 Naturally, they have costs, which cut into
investors' income, but the amount of those
charges cannot be determined by an outsider.
That uncertainty detracts from the annuity's
appeal. What investors do not know might indeed
hurt them. In fact, it probably will. As a general

Forty-Nine Too Many

As insurance offerings, annuities are subject
to various state regulations-which, unfortunately,
may differ from one state to the next. For example,
should an insurance company fail, its annuity
owners won't necessarily be left high and dry. As
with bank CD owners, the safety of their purchases
is guaranteed by a government body, up
to a certain level. However, whereas the Federal
Deposit Insurance Corporation protects all CD
holders by the same amount ($250,000 per bank),
the annuity guarantee varies by state.
Fifty sets of regulations is 49 too many. There may
be a role for state-insurance departments, with
enforcement or in crafting regulations for
situations that are unique to that state, but setting
individual policies where one national set
of standards will do is not one of those roles.
Beyond Marketing

In sum, to make annuities more attractive, I advise
that they be renamed as "guaranteed income"
offerings; that they calculate and publish their
expense ratios; and that the cacophony of state

1 "Annuities May Be a Smart Fit for Your Investment Plan." https://www.nationwide.com/annuity-investments.jsp
2 The exception being variable annuities, which behave like mutual funds by investing in a specified pool of securities and, thus, carry an expense ratio that is similar in structure to that of a
mutual fund-although generally much higher.
3 "SEC, FINRA Warn Retail Investors About Investing in Structured Notes with Principal Protection." June 2, 2011. https://www.sec.gov/news/press/2011/2011-118.htm

global.morningstar.com/Morningstarmagazine

https://www.nationwide.com/annuity-investments.jsp https://www.sec.gov/news/press/2011/2011-118.htm http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018