Annuities Are Like Air-Bags For Your Portfolio

The concept of an annuity, a promise by one party to make a series of payments of a specific value to another for a given period of time, or until a certain event occurs (such as the death of the person receiving the payments), has been around since at least the Roman Empire. The history is too long and varied to address here, but for a financial concept that has been around for so long, the reputation of the annuity has certainly endured a roller-coaster ride in modern times. Once in vogue, then utterly derided, and now seemingly back in style, the very basic annuity structures of the past, added to the ever-changing options available today, may look quite different in some respects. In most ways, however, the fundamentals and considerations remain the same. 

With the multitude of different annuities available today, and the intricacies of the often dizzying confusion of bells and whistles available, the process of vetting and selecting an appropriate product can be quite overwhelming. It is also not the focus of this article. Instead, we hope simply to help frame the broader question of who may be a good candidate for an annuity, and why.  As it turns out, the answer here, as is often the case with financial products, comes down to qualitative issues rather than quantitative ones.

The basic structure of a modern-day annuity, is essentially an insurance contract, which, at its core, presents a trade-off. You agree to give up to the annuity (insurance) company, the productive use of your money today, for a promise of a constant income stream in the future.  Regardless of what happens with the equity markets, bond markets, or economy as a whole, the insurance company has made you a promise, and it is contractually obligated to keep that promise.  You have, in effect, transferred the risk of returns (or lack thereof), from yourself, to the insurance company.

Of course, the insurance company is charging you for this transfer of risk. You may be charged an upfront commission, an internal fee, a surrender charge, or some combination of all of these. These fees may not always be easy to find (one of the reasons annuities have suffered from a bad reputation in the past), but believe me, they are there.  And, what we all know is that any time you layer additional fees on top of any type of investment program, you are “statistically” lowering your upside return potential.   All things being equal, higher fees equals lower returns. So, from a purely statistical standpoint, it can be hard to see why one would ever choose to use this kind of product, right? 

The fact is that very few people are truly rational or base their decisions purely on statistics, and this is especially true when dealing with money and investing.  The fallacy of the rational investor is well founded, and once we understand that behavior is the single most important variable for the outcomes of most investors, we can start to see where an annuity might come into play.  For any investor, who needs growth from his or her investment assets in order to reach certain goals, but is unable to be rational in the face of inevitable market volatility over the long-run, paying an extra layer of fees, to transfer the investment risk to the insurance company, may be worthwhile.  In that case, higher fees equals peace-of-mind, which in turn translates into higher return potential, as a result of simply staying invested.

But let’s switch gears for a moment. Most people in the market for a new car, would never even consider buying one without air bags, assuming you could even find one that didn’t have them.  These days, however, you may be faced with a choice of just the basic air bags, or the deluxe package, with side curtain, back seat and any number of other additional air bags included. Of course, a car with the basic package, all things being equal, will cost less than a car with the deluxe package.  If you’ve done your homework, however, you’ll know that the average person gets into an accident about every eighteen years, and buys a new car about every four or five years. Of those accidents, roughly 0.3% are fatal, which means that the vast majority of people will never need any air bags, let alone the deluxe versions. So, does this mean that we (or at least a pure numbers person), should save the money, forget the air bags, and play the statistics? Even if we believe this would make sense, we know this is not what people do.

While the preceding analogy may seem fairly labored, owing to the fact that comparing loss of life to loss of investment assets is a bit extreme, the fact is that, to many, subjecting their life’s savings to the volatility of the markets, can feel a bit like life and death at times. It’s not, of course, but it illustrates the point nonetheless.

What we do know is that real people go ahead and pony up for the air bags, and in doing so, shift the decision from a statistical one (quantitative) to a behavioral one (qualitative) by deciding that the extra layer of cost is worth the peace-of-mind that it brings.  Simply from the knowledge that they have this extra layer of protection, people are likely to worry less, and this in itself probably makes them drive better.  And, of course, in the unlikely event that a major crash does occur, they are surely happy to have paid for the extra protection.

The same is true with investing, and this is where annuities can play a role. What we have seen through the years is that those who do have annuities, are often able to invest better with the rest of their assets. Because they know they have the protection of annuities in place, they are able to weather the volatility and stick to their long-term plans. This emotional reassurance allows them to avoid making the kinds of irrational decisions with their portfolios that other, less-protected investors tend to make.  And if they do see a major market crash, they will likely be quite happy to have paid the extra fee for the extra protection.

As with most financial products, the annuity is neither the answer for everyone, nor the villain it is so often portrayed as. It is merely one tool that can be highly effective, given the right circumstances. This is why it is so important for clients to be honest with themselves and their advisors about their risk tolerance, and their emotional reactions to different market conditions. Because in the end, if you’re prone to making knee-jerk reactions to normal market volatility, it might just make sense to pay a little extra for the ‘deluxe’ package, in this case, the protection offered by annuities.