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Many advisers have joined the Retirement Income Journal community recently, and many of them are new to the world of annuities. I’ve been asked to create a quick tutorial on this complex topic, if brevity with annuities is possible.

Annuities are special tools for investors who are willing to give up part of the upside potential of their investments in return for some protection against the downside risk. Unfortunately, to everyone’s confusion, most journalists mash-up the characteristics of different types of annuities when describing them.

All annuities do share certain qualities: They offer tax benefits, only life insurers can issue them, and every contract allows the owner to convert the underlying assets into an annuity—an income stream that will last for a certain period or for the owner’s entire life.

But the similarities end there. I first divide annuities into two categories: those used primarily for asset accumulation before retirement and those used primarily for generating income in retirement. Within each of those two major categories, I indicate the different ways they are invested: in mutual funds, bonds, or options.

Bear in mind that this article covers only the crests of the annuity mountain range; there are not only endless valleys but also countless cave systems waiting to be explored. Each of the product types described below exhibits almost infinite variation, and the variations themselves fluctuate over time.

Annuities for asset appreciation (before or during retirement)

Using bonds (with no risk of loss). Suppose you’re looking at certificates of deposits as safe short-term investment but the yields don’t interest you. You might look at fixed deferred annuities. You hand your $100k over to a life insurance company. The insurer puts your money into its general fund, where it earns about 4% per year. It subtracts its expenses—say, 1.5%—and pays you 2.5% a year. You have no risk of loss. Advisers must have insurance licenses to sell these products.

Using mutual funds (with risk of loss). You may have a large sum—up to $1 million or so—that you’d like to see grow tax-deferred for several years. You’ve already contributed the maximum to tax-deferred accounts like IRAs or 401(k)s. You’d also like to trade funds without generating taxable gains. Consider a deferred variable annuity. You invest in a mix of stock, bond or balanced mutual funds. The money resides in a “separate account” (outside the insurer’s general account) with your name on it. The mutual funds can gain or lose value, so you have a risk of loss. Only advisers with security licenses can sell this product.

Using options (with zero risk of loss). What if you’re unsatisfied with fixed annuity yields but don’t want to take the risks associated with mutual funds. You might compromise by purchasing a fixed indexed annuity (FIA). You hand your $100k over to a life insurance company. The insurer puts your money into its general fund, where it will earn about 4% per year. Then, instead of paying you 2.5% per year, it spends that $2,500 on options on an equity index or exchange-traded fund.

If the index goes up and the options pay off, you participate in the gain. You can’t lose money if you hold the contract until it expires at the end of a 1, 3, 5, 7 or 10-year term. You can—but aren’t certain—to gain one or two percent more than if you had bought a fixed deferred annuity. Advisers with insurance licenses can sell these contracts.

Using options (with limited risk of loss). What if you like the idea of a fixed indexed annuity but you want a chance for higher gains and you’re willing to accept a limited risk of loss? Then you’d be talking about products called structured variable annuities (aka registered index-linked annuities or RILAs). You’ll be investing in options, but this time you have a wider range of possible outcomes. You might, for instance, lose up to 10%, or you might incur the net loss beyond the first 10%, but your potential gain is higher than any FIA can offer.

Annuities that produce retirement income

Using bonds, with mortality pooling, with limited liquidity, starting now. You’re ready to retire and start living on savings. You don’t have a pension. You have Social Security but it won’t cover all your basic expenses. You’ve heard that you can’t spend more than 3% of your savings each year without a risk of running out of money before you die. You don’t have a pension, but you’re willing to buy one of your own, with part of your savings (tax-deferred or taxable). You can buy a single premium immediate annuity (SPIA). Your premium goes into the insurer’s general fund, sequestered with the money from other people your age.

In return, you receive a fixed, guaranteed monthly or quarterly income for life or for a specific period of years (perhaps as part of a bucketing or income-laddering strategy). The safe annual payout will be about 5% of your initial premium. That’s more than the safe withdrawal rate because you’ll receive a bit of the original principal, a bit of the interest on the bonds in the general funds, and a bit of the assets of other annuity owners who die before you.

Using bonds (with mortality pooling, with limited liquidity, starting some years from now). Let’s suppose that you like the product just describe, but you want to delay your first payment for several years. A deferred income annuity (DIA) will do the job. Everything works the same as the single premium immediate annuity, but your income starts years in the future.

Using mutual funds (without mortality pooling, with full liquidity). Remember the variable deferred annuity from above? Imagine that a special feature of this product allows you to switch income on, switch it off, or take as much of your money out whenever you like—but still promising you (as long as you restrain your spending) that if your own money runs out before you die, then the insurance company will continue making monthly payments to you until you die. This special feature is called a guaranteed lifetime withdrawal benefit (GLWB).

Using options, without mortality pooling, with full liquidity. Imagine the GLWB I just described, but attached to a fixed indexed annuity instead of a variable deferred annuity. Contract owners buy the contract, receive interest credits and bonuses for up to 10 years, and then start receiving a guaranteed minimum amount of monthly income for life. They never lose access to the account value as long as it’s positive.

Using bonds, with mortality pooling, with limited liquidity, starting a few years from now, for distributions of qualified money after the Required Minimum Distribution start date. Invented by the U.S. Treasury in 2014, this product resolves a technical problem for people who couldn’t buy deferred income annuities with tax-deferred money from a 401(k) or traditional IRA because it would have conflicted with their obligation to begin withdrawing money from those accounts at age 70½ (now 72). The IRS now allows taxpayers to apply 25% of their tax-deferred savings (up to $130,000) to the purchase of an income annuity whose payments begin between age 72 and age 85.

Less common annuities

Medically-underwritten or “impaired annuities”. It’s a myth that people in poor health should not buy SPIAs because they’re likely to die before they get all their money back through monthly payments. But at least one life insurer (Mutual of Omaha) will enlarge the monthly payouts from a SPIA for people in poor health. They simply revise the person’s age upward. A 65-year-old man with a heart condition might be charged the same price for the annuity as a 72-year-old man in better health.

Charitable remainder annuity trusts. These contracts are useful for retirees who want guaranteed retirement income and a tax deduction for a future contribution to charity. The donor typically pays into a charitable trust, which pays the donor a fixed income stream until he or she dies. Any money that remains in the trust at the donor’s death goes to the charity.

Secondary market annuities. When the victim of a serious accident wins a large settlement in a personal injury lawsuit, the settlement often includes an annuity that pays an income for a specific number of years. To convert the annuity to cash, the injured party might sell it, at a discount, to a settlement company. The settlement company will then sell the annuity through a broker to a member of the public who wants a specific payout at or over a specific time.

Such contracts have been controversial, because in some instances accident victims accepted less than fair compensation for their annuities. The industry has largely survived legal scrutiny, but the supply of secondary market annuities is small. What’s the attraction? Their payouts are said to be about 15% higher than the payouts of retail period-certain single premium income annuities.

Conclusion

Annuities are also accused of complexity. When they are, it’s partly because so many mathematical variables—interest rates, volatility levels, mortality rates, the number of people who keep their contracts or surrender them—enter the calculation of whatever financial outcome the life insurer has promised the purchaser.

Annuities are also accused of having high costs, and sometimes they do. That’s partly because annuities are investments with warranties—you’re paying an insurer to absorb the cost of a market crash or the risk that you’ll outlive your savings. Traditional stocks and bonds make no promises, and the owner bears both the upside and the downside risk. Annuity fees can be high when the life insurer recoups the upfront fee that it pays a broker—unless the purchaser pays the broker himself—by charging the client annual fees.

© 2020 RIJ Publishing LLC. All rights reserved.

Issuers of fixed indexed annuities (FIAs) generate returns for contract owners based mainly on the movement of equity indexes. By purchasing options on the indexes with part of the income they glean from investing client money in bonds, they can capture some—but not all—of the index growth.

Low interest rates and high market volatility are headwinds for FIA issuers. Low rates can squeeze the issuer’s budget for buying option. Volatility can drive up the cost of options. But, internally, FIAs contain many levers and dials that an issuer can manipulate to burnish a product’s curb appeal.

Two powerhouses of the FIA world, AIG Life & Retirement and Scottsdale-based Annexus, a designer and distributor of FIAs, use almost every possible tool to enhance X5 Advantage, a new FIA with a non-optional lifetime income benefit. AIG’s American General Life subsidiary is the issuer.

The X5 Advantage orchestrates a symphony of deferral bonuses, a long surrender period, embedded fees, leverage, risk-sharing negative floors, assumed lapse rates, volatility-managed indexes, caps, participation rates, spreads and finely-tuned age-based payout rates to serve a surprising number of purposes.

With only a small bit of skin, indirectly, in the equity markets, X5 Advantage aims to satisfy the revenue needs of the life insurer, the distributor, the agent/adviser, and—eventually—to mitigate a client’s market risk, sequence risk, mortality risk, longevity risk and nursing home risk.

Impossible? Not if you hold it long enough. Like a tough cut of beef that becomes fit for a king if you cook it for a long time at a low temperature, this product aims to turn the little that the market offers right now into a feast for everyone involved. It’s a marvel of financial engineering.

Bonuses are the key

X5 Advantage has two stages: An accumulation stage that starts at purchase, and an income stage that starts no less than 10 years later, at the end of the surrender period. During the accumulation stage, the client gets interest credits based on the performance of options on volatility-managed equity indexes from PIMCO, Morgan Stanley or S&P.

The payout rate doesn’t reach 5% of the benefit base until age 70 for a single person (4.5% for a couple), but there are bonuses. During the accumulation stage, the benefit base (equal to the premium at the time of purchase) rises by 200% of each year’s earnings. During the payout stage, the benefit base rises by 150% of the annual earnings.

Here’s how AIG illustrates the product in its brochure. John, a 60-year-old who plans to retire at age 70, funds his X5 Advantage with a $100,000 premium and chooses a 10-year strategy with two five-year terms. Ten years later, his account value is $165,772. But, thanks to the annual bonus, his benefit base has grown to $247,937.

At age 70, and not before, John begins drawing an annual income of 5% of the benefit base, or almost $12,400. The benefit base, and the income stream on which it is based, both keep growing after income begins, by the aforementioned 150% of annual credited interest. These are better terms than a deferred income annuity (DIA) with 10-year deferral period could promise. Anecdotally, that’s partly because FIAs have higher lapse rates than DIAs, which are virtually illiquid.

If John becomes ill and needs nursing home care, he can receive double the usual income amount for up to five years. There are two death benefit options. If John died at age 70, for instance, his beneficiaries could get either his account value ($165,772) in a lump sum or his benefit base ($247,937) in five annual payments of $49,587 each.

Participation rates, spreads and risk-sharing

Those are the bonuses. What about the caps and participation rates on the interest crediting methods? The issuers carefully manage the portion of the index gains the FIA owner can lock in at the conclusion of each one-year, five-year, or ten-year crediting term.

And what about the indexes? In this case, the three custom indexes all contain volatility controls that can dampen the index gains from the inside and take out the market spikes.

Contract owners can get exposure to the Morgan Stanley Expanded Horizons Index, the PIMCO Global Elite Markets Index and an S&P 500 Daily Risk Control 7% USD Excess Return Index. The box below lists the current crediting rates, according to AIG’s product rate sheet.

From the X5Advantage Rate Sheet

As an example of volatility control, let’s compare the S&P 500 Daily Risk Control 7% USD Excess Return with the traditional S&P 500 Index. The risk-controlled version has a net one-year return of 3.87% while the traditional version has a one-year return of 2.31%. The “Excess return” part of the index name reflects the fact that the investment is leveraged; the contract owner gets the portion of the return (3.87% in this case) that was in excess of the cost of borrowing money to do the leveraging.

Looking again at the box above, you can see more of the dials and levers that allow the issuer to fine-tune the risk/return proposition. For instance, two of the crediting strategies have 1% “spreads.” That means the contract owner would get the participation rate (100%, 60% or 40%, depending on the strategy) of the index return minus 1%.

Both the five-year and 10-year strategies have a minus-5% floor on possible losses in any one-year or two-year term within a crediting period, respectively. (But a negative return for the entire crediting period is guaranteed not to occur.) This risk-shift to the client allows the issuer to advertise slightly higher caps by shifting some of the investment risk to the client.

The one-year strategies have participation rates that are less than 100%. If the index gained seven percent, for instance, the client gets either 45% or 60% of 6% (2.7% or 3.6%) depending on which index he or she chose. The one-year option also has a 1% spread, which is subtracted from the credited interest. It also has participation rates, which are alternatives to caps.

To protect the issuer, the rates are subject to change by the issuer at the end of each crediting period. To protect the client, there are guaranteed minimums. The five-year crediting strategies have a minimum participation rate of 50%, a maximum spread of 3%, and a minimum index term floor of -10%. The one-year point-to-point crediting strategies have a minimum participation rate of 25% and a maximum spread of 3%. The ten-year crediting strategies have a minimum participation rate of 50% and a maximum spread of 3%.

As good as it gets

The past dozen years have been tough for annuity issuers. With low bond yields reducing the return on their fixed income assets, but a booming equity market, they’ve had to create products, such as variable and index annuities, that tap into the bounty of the long bull market. It creates a lot of complex engineering to interface an insurer’s general account with the equity markets without violating any state or federal regulations.

For indexed annuities to do a lot with a little, they also need time. But as long as the contract owner holds onto the contract and follows its rules, several of his or her major retirement risks will be addressed. For near-retirees who can’t afford a fee-based adviser, products like the X5 Advantage may be as good as it gets under current market conditions.

© 2020 RIJ Publishing LLC. All rights reserved.