Kerry Pechter: How Annuities Fit Into the Retirement Income Puzzle
The author and columnist unpacks the benefits and limitations of annuities in an era of ultralow yields.
Our guest on the podcast today is Kerry Pechter. He is the editor and publisher of Retirement Income Journal, which he launched in 2009 to provide unconflicted news and analysis to the annuity and financial advice industries. RIJ recently celebrated its 500th issue. Kerry is also the author of Annuities for Dummies and two other nonfiction books. He has been an editor of Annuity Market News, a writer in Vanguard's individual annuity marketing department, a senior editor at Rodale Press, and a reporter for The Billings Montana Gazette.
“Out of Commission,” by Kerry Pechter, retirementincomejournal.com, Sept. 19, 2013.
“Seeking ‘Ambidextrous Advisers’,” by Kerry Pechter, retirementincomejournal.com, Jan. 9, 2020.
“Will Fee-Only Advisors Warm to Annuities?” by Kerry Pechter, retirementincomejournal.com, Oct. 19, 2018.
“Two Client-Centric Income Strategies,” by Kerry Pechter, retirementincomejournal.com, Jan. 10, 2019.
“A Primer for Annuity Newbies,” by Kerry Pechter, retirementincomejournal.com, May 28, 2020.
“Another Advantage of Annuities: You Can Be More Aggressive With Non-Annuity Funds and Fare Better Long-Term,” by Kerry Pechter, annuityfyi.com.
“The One True Path to Income--The New DIAs,” by Kerry Pechter, annuityfyi.com.
“Now You Can Invest in a Longevity Annuity Within an IRA or 401(k),” by Kerry Pechter, annuityfyi.com.
“The Catch-22 of In-Plan Annuities,” by Kerry Pechter, retirementincomejournal.com, Dec. 17, 2020.
“'Dull' Investments Shine in a Crisis,” by Kerry Pechter, retirementincomejournal.com, March 26, 2020.
“Why Is Income Planning So Hard?” by Kerry Pechter, retirementincomejournal.com, June 30, 2020
“Stormy Weather for Life Insurers,” by Kerry Pechter, retirementincomejournal.com, April 9, 2020.
“Low Interest Rates Shock Sales of Most Annuities,” retirementincomejournal.com, Aug. 6, 2020.
“Pandemic Hurt Annuity Sales in 2020,” by Kerry Pechter, retirementincomejournal.com, March 10, 2021.
“Trends RIJ Will Track in 2021,” by Kerry Pechter, retirementincomejournal.com, Jan. 7, 2021.
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar.
Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Benz: Our guest on the podcast today is Kerry Pechter. He is the editor and publisher of Retirement Income Journal, which he launched in 2009 to provide unconflicted news and analysis to the annuity and financial advice industries. RIJ recently celebrated its 500th issue. Kerry is also the author of Annuities for Dummies and two other nonfiction books. He has been an editor of Annuity Market News, a writer in Vanguard's individual annuity marketing department, a senior editor at Rodale Press, and a reporter for The Billings Montana Gazette.
Kerry, welcome to The Long View.
Kerry Pechter: Thank you for inviting me, Christine.
Benz: Well, it's great to have you here. We wanted to start by talking about Retirement Income Journal, which you founded. What prompted you to start the publication and what audiences are you trying to serve with the website?
Pechter: The origin story is that I was working at The Vanguard Group about 20 years ago when Vanguard started serving Social Security systems overseas and running their money, big tranches of money from, say, France or Australia. And I talked with the people in that department and they said, there's a global retirement crisis and there's trillions and trillions of dollars involved. It's everywhere. Every country experienced that boomer wave, and it's all hitting now. And I said, really? And I got very interested and started reading about that and reading about comparative Social Security systems. And I had already been in the Retirement Resource Center at Vanguard and I was assigned to annuities. I was the village explainer of annuities to our investors. And Vanguard didn't sell annuities. It did some white label annuity marketing, but it didn't own an insurance company, it didn't sell them.
So, I became very interested in that, wanted to go back to journalism where I'd been before I went to Vanguard and to write about this phenomenon. So, I took a job at Source Media, a publishing company in New York, that was publishing Annuity Market News. So, I went remotely to work for them in New York. And then, what happened was that in the financial crisis, they just simply killed a whole bunch of magazines of their smaller titles, including Annuity Market News, and I lost my job in March of 2009.
So, I got a couple of calls from the life insurance industry and the annuity industry saying that they still needed a publication, and could I keep it going. And that's what I did. I put a new name on it. I set up a platform online and published it for about nine months for free. And then, I put up a paywall, and miraculously, because you don't count on any of these things happening, the life insurance industry responded enthusiastically and posted the corporate subscriptions and single subscriptions that were necessary the start and to keep it going.
Ptak: Annuities are a key focus at Retirement Income Journal. It seems there is a growing recognition that there could be a role for annuities in many retirement plans. But among financial advisors, there has historically been a rift between those who are insurance people and those who focus on investments. Is it your sense that that distinction is breaking down a bit? And if so, why is that happening?
Pechter: Well, here at RIJ, we promote the concept of the ambidextrous advisor, the advisor who can look at things from the insurance view and from the investment view, and there's a reason for why that's important. The difference between those two things is sometimes misunderstood. Insurance is fundamentally a risk-transfer operation. You are transferring risk to a company and you are paying them a fee for doing it, because they are going to charge you for handling the risk on your money. Let's say, you have $100,000; you want it to be worth exactly X in 10 years, or you want it to be never to be less than X. They will make a deal and they will write you a contract and they will charge you for that. And that's risk transfer away from the individual.
Investments is risk purchased by the individual and the individual mainly pays for the advice, but it is a risk acquisition. So, you have risk on and risk off and those are completely different worlds. And mainly, the risk-on people specialize in risk on and risk-off people specialize in risk off. The situation changes though when people retire, and that's when their whole risk budget changes, and they become far more conscious of the risks they face: market risk, inflation risk, longevity risk. And that brings up the idea of insurance. Before the retirement date or before you are approaching the retirement date, risk on is fine. And things like sequence of returns don't really matter. But as you get into retirement, it's a different risk picture. And that's why insurance products and insurance comes into view at the same time as retirement. Now, if you've had an advisor who has only done risk on for your entire career or your entire relationship with him, or her, that advisor may know absolutely nothing about tailoring risk off and dividing up your risk budget in a way that you find palatable.
Benz: I recently spoke to a financial advisor who is knowledgeable about annuities. And he said he sees a lot of registered investment advisors, RIAs, automatically throw annuities overboard when they take on new clients who happen to own them. And his remark was that sometimes these products have features that would be really hard to replicate in the current environment, either through an annuity or certainly through a pure investment. So, do you think that's a problem, this sort of reflexive avoidance of annuities by some advisors?
Pechter: Well, there's a couple of answers to that. The RIAs are risk-on people. And they probably don't say that they are not wary of risk, but they do believe that risk can be handled mainly with diversification. And when they get a client who has a variable annuity--it's usually variable annuities, because those are the ones that are kind of open ended, they don't have terms--they have this money in the variable annuity, and they ask the client, “What is this?” And the client says, “I have no idea.” And those annuities can easily be transferred out to another tax-deferred vehicle. But the particular problem here is that there were annuities written 10 years ago, variable annuities with lifetime-income guarantees that were very, very rich, so rich that they drove a lot of those companies out of business. I won't name them, but many of them were owned by European owners, and they couldn't stay in the business because they had promised too much, too high an income in retirement.
Now, if your client has one of those overly rich products, say, that pays out 10% of your initial premium when you get to retirement for life, and you dumped that annuity, then you've done your client a terrible disservice. He will have paid a bunch of fees for nothing. He will just be throwing away the insurance and all the premiums will be gone. And also, it's not fiduciary to do that, to throw out that kind of benefit. So, an RIA has to be careful. There are advisors who advise and have tools that evaluate annuities, the variable annuities, to see whether they're worth keeping or not. And that's something that a fiduciary should really do before they just get rid of it. Other than that, it's a matter of whether the annuity is serving its risk-off purpose. Why do you do risk off? You do risk off to create risk on in other places.
Ptak: One argument you sometimes hear against advisors charging a percentage of a client's assets under management is that there might be a disincentive to recommend an annuity because once the client buys such a product, it's no longer in the advisor's book of business. Is that a real issue do you think?
Pechter: Oh, absolutely. Advisors do what they get paid to do. They don't give advice on reverse mortgages. They don't give advice on healthcare, because they can't bill for these things. And generally, they just don't do what they can't bill for.
Benz: So, on the other hand, many advisors and consumers quite reasonably view the annuity space as full of high-cost, high-commission products and conflicts of interest. There are a lot of reasons to be wary. So, is the landscape getting better for would-be annuity purchasers? And is it getting easier to buy annuities without high commissions attached to them?
Pechter: Well, the commissions are high because the products, it seems odd to say, but because the products are hard to sell. And turning that around, you have to pay an advisor or an agent a lot of money to sell these things, because they're going to drill a lot of dry holes. And it's by no means a perfect world. But it's simply the economics of the situation, that if you want to sell a complicated product that's risk off, then you're going to have to incentivize the advisors. That's why annuities are almost sold in order of how high the commission. They are prioritized by the advisor community in the order of the commission. But now, that's changing a bit because we now have platforms--as the fixed-indexed annuity has been brought in from the cold, sort of, as a product. You have platforms like RetireOne and like DPL Financial, where an RIA can go and get one of these fixed-indexed annuities. And those platforms are prospering.
Ptak: Yeah, that's a good segue to the next thing that we wanted to talk about, which is, some of the basics regarding annuities, knowing that some of our listeners are maybe more or less familiar with those basics. There are so many different annuity types, and they are all so different that the term almost isn't that helpful. What do you think is a sensible way to group them? Are the three main categories, fixed, variable, and fixed indexed? Or do you sort them in some other way?
Pechter: No. When I wrote Annuities for Dummies, I set out to solve that problem. And the book begins by saying that you can't speak intelligently about annuities in general. Annuities are a set of maybe six, seven, eight, maybe even more, completely different kinds of products that are only called annuity because in order to get tax deferral they must have a clause in the contract that says you can convert the assets here to a lifetime-income stream. And that's almost, not quite, but it would be a big exaggeration to say that that's the only thing that they have in common. But besides that, they just completely go off in different directions. Some of them are bond-based, some of them are equity-based, some of them are designed for tax deferral mainly. Some are for saving, some are for long-term investing and trading on a tax-deferred basis.
The taxonomy that you just used--fixed and variable and then fixed indexed--is when someone starts that way, that's the path to total confusion. And that's what most people read in the newspaper and it will lead them completely in the wrong direction. You have annuities for lifetime income; you have annuity for risk-buffered growth; you have annuities for tax deferral; you have annuities for basic savings. It's an insurance product, and you have to identify the risks that you are trying to mediate, or get off your plate, to make room for other risks before you can even talk about the kind of annuity that you are interested in. There's no such thing as annuities generally. Pretty soon there's going to be no such thing as ETFs. As they specialize, it will probably become confusing to just talk about ETFs. But annuities passed that bar a long time ago. It makes no sense to talk about them in general.
Benz: So, your risk framing I think is a really helpful way to think about that. You've said that a good starting point for deciding whether an annuity makes sense in a certain situation is to think about what risk you're trying to reduce. Can you walk us through that thought process to help us understand how certain annuity types might mitigate one risk or another? So, if we think about someone who is worried about longevity risk, for example, can you talk about what products would naturally come up in that context and so on down the line?
Pechter: Sure. Let’s say a person or a couple comes to an advisor. And they are worried. And they are in their late 50s, early 60s, and they don't know what they are going to do about retirement. They mainly have questions. They don't even know what the concept of longevity risk is. And so, this is what happens a lot right now. And so, the advisor, if he is, say, a broker/dealer advisor, who now sells annuities, he might say--and many of them will say right now: “Well, I think you should be interested in the thing that will relieve, what ails you, the headache that you have.” The headache is usually: I'm afraid to go long, I'm afraid to go short, I'm afraid that the markets are going to go up, I'm afraid the market might go down, and I can't afford to lose any more money and I'm paralyzed. The fixed-indexed annuity and its companion, the registered index-linked annuity, are the remedies du jour for that situation. That would be the most common situation.
And when you get into things like income annuities, we're talking about a completely different ballgame, because income annuities would be sold by a different kind of distributor. That's another thing that people don't understand--that certain channels of distribution, certain kinds of agents and advisors sell certain kinds of annuities, and others do not. You're not going to go to an advisor and have him lay out: you could do an income annuity, you could do an indexed annuity, you could do a variable annuity. That is never going to happen. Since they are unrelated, they are not proposed as alternatives to each other. And then, they also have ways of different compensation. I don't want to confuse the average reader with how complicated the distribution system is. But they should just know that the advisor that they go to is going to be interested in selling certain kinds of annuities and not others.
Ptak: So, maybe if we were to put some of those issues, like incentives and distribution nodes aside, if we were to go back to your example of someone who is concerned their portfolio might not last throughout their retirement, what annuity type would you recommend? I think there were a few that you mentioned that you thought might be fit for purpose. But just to pin you down, in a situation like that one, is there a type that's preferable?
Pechter: Well, you've got four options basically. If you can't tell by now, any discussion of annuities quickly becomes extremely complicated. And maybe people will be able to go back to this recording and recognize some of the high spots and keep that with them. Now, we don't want to get too complicated. But let's say, a person says I'm afraid of outliving my money. And this is usually be a person who is looking at the amount of money they have, and they divide the number of years they think they're going to live, and they can see that it might not last. And this is sometimes called the red zone or the constrained investor. And that person has, I would say, four basic options. They can do an indexed annuity with a lifetime-income benefit; a variable annuity with a lifetime-income benefit, an income annuity that starts within a year after you buy it starts producing income, and a deferred-income annuity where the income doesn't start until well after the end of the RMD period. And if you want a tax-deferred version, that's available too. It's called a QLAC, qualified longevity annuity contract.
Now, those are all very different products and they divide easily into two parts. The fixed and the indexed and the variable annuity with lifetime income benefits offer liquidity throughout the life of the product. That is, you can lock in a certain income for life, but you can also go in and get some of your money out if you have to in an emergency. And that's been very popular. There is a catch. The catch is that if you take out money, your income drops proportionally. So, it doesn't put the money out of your reach. But that's very popular. People are very, very unlikely to want to give up liquidity in order to get lifetime income and the insurance companies have come up with a couple of ways for them to do that.
Now, the other way, the income annuity and the deferred-income annuity, those are irrevocable products. They are not particularly profitable, because you can't really change your mind after you buy them. You generally, pound for pound, get a higher income from them, because they are irrevocable and because, as any bond investor knows, you get an illiquidity bonus, because the insurance company can invest in longer bonds and doesn't have to prepare for the possibility of people liquidating part of their annuity.
So, you have the irrevocable annuity, the deferred income or the income, and you have the liquid annuity, the fixed indexed and the variable, both of which have lifetime-income guarantees available on them.
Benz: So, you mentioned the life annuities, the very basic products. It often seems that people who I consider to be good-quality financial planners prefer those annuity types to the extent that they would recommend any annuities at all. And they basically say, all this other stuff is junk, whether variable annuities or fixed-indexed annuities. Is that too narrow a view, in your opinion?
Pechter: Well, it's not too narrow a view. But we'd rather not use words like “junk” and differentiators like that. It would be better to say, look, those products, those income annuities, have not sold. Insurance companies have had to find other products to sell that people will buy. And those products are sold as investments rather than as income vehicles. They are sold as safe investments. And the insurance industry has put itself in a difficult position, because when they present these products as investments, which as I said are risk on, and then they charge a lot and then people can't figure out why they cost so much compared with investments. It's because they are marketed as investments, but they are not; they are insurance and insurance costs, the guarantees, cost a fair amount of money.
So, remember I said that that the only thing that these annuities have in common is the clause that says you can convert the underlying assets to a lifetime-income stream? Well, that's the annuity part. And that's what he means when he says the rest are all junk, because it's the income annuity that is the only real annuity. An annuity is a lifetime series of payments. The others have the annuity thing built in, but they are really investments that straddle the line between insurance and annuities. So, the pure annuity, a basic annuity, the organic Birkenstock-wearing product, original product is the lifetime annuity.
Now, you said planners. Planners are different from RIAs and broker/dealer reps. And planners look at the whole entire household and the planners say, “OK, let's say, you are going to get $4,000 a month from Social Security and you need another $300,000 a month minimum, and you have $1 million. What we're going to do is, we're going to take the difference between your Social Security and your need, which is $3,000, we're going to buy an income annuity that's going to put a check in your mailbox, or ACH, every month for as long as you live no matter how long you live, and then you are going to take your other $0.5 million or whatever it is, or $600,000, and you are going to invest them in stocks for the next 25 years. And you are not ever going to have to think about, worrying about what's going on in the market, because you are going to be getting your $7,000 every month from Uncle Sam and from the annuity company.”
And that's why planners sell income annuities to people. Those types of planners--they are two kinds. They are either the no-fee, the fee-only, the hourly only type of advisor; or they are captive agents of mutual insurance companies. If you don't go to a captive agent of a mutual insurance company, you may never hear about an income annuity, because they primarily manufacture them, and they primarily sell them.
So, I'm starting to cross my wires here, because they do get crossed between the distribution channels and the annuities product. And they are like wheels within wheels. It's like, which kind of company with which kind of advisors sells which kind of annuity. And because of all those permutations and combinations, that's why annuities are such a thicket.
Ptak: One aspect that maybe is a little less ambiguous is the tax advantage of annuities. So, how should investors and their advisors think about those tax advantages? And do you think those potential benefits are sometimes oversold?
Pechter: Well, it all depends on whether you need them or not. There is a type of variable annuity that's called investment-only. And it's chock-full of all kinds of mutual funds. They are called portfolios; they are not allowed to be called mutual funds because they are tax deferred. But they have investments inside them. And the variable annuity is unique in that it is the only tax-deferred vehicle where a wealthy person can put as much money as they want for a long-term tax-deferred growth, and this is important, tax-deferred trading, so you don't build up a tax bill during the year from trading. So, there is a benefit from long-term tax deferral and then there is a benefit of shielding from short-term trading. That would probably be the most likely use of annuities for tax purposes.
Another way of using annuities for tax purposes is if you have a bunch of nonqualified money, after-tax money, and you have capital gains built into it. If you put that into an income annuity, there is going to be an exclusion ratio so that your tax on that is going to be spread out over the life of the annuity rather than hit you all at once. That's a big difference between the income annuity and the variable annuity or indexed annuity with a lifetime-income benefit. With those products, with the lifetime-income benefit, you have to take out the gains first. So, it's all gains coming out first. Whereas with the income annuity, that's irrevocable, the internal gains get spread out over the life of the contract.
Now, what I should mention about the income annuities, and to go back to that point about the financial planner and his reference to the others as being junk--that's because the alpha of annuities, the beauty part, the essence of an annuity, of a true annuity, is the mortality credit or survivorship credit, to put it a little more positively. And the survivorship credit is the credit that you get from pooling your own longevity risk with other people, which means that when other people in the pool die, you get a credit because they have died. And that's why the longer you live, the more that pays off. So, no other type of annuity offers the mortality credit and it might be said that the mortality credit is the very best thing that annuity has to offer.
Benz: Based on what you've just said regarding the tax benefits, it sounds like it's an additional source of tax deferral that one could use taxable assets in this context and obtain some tax deferral. I often hear advisors rail against other advisors who use IRA assets to buy annuities. Is that always a bad idea? You mentioned the qualified longevity annuity contract that is specifically for tax-deferred assets. So, can you walk us through that, when it makes sense to use tax-deferred assets and with which types of products?
Pechter: Well, if your money is already tax-deferred, it's redundant to put them in another tax-deferred product. And you wouldn't do that unless there was a separate reason. And the variable annuity folks have tended to justify the purchase of their tax-deferred product with a tax-deferred rollover, they've justified on the basis that you can get these living benefits. And there is certainly no problem with using tax-deferred assets to… Most Americans, the middle class in America, is going to have most of their money in tax-deferred accounts, in retirement accounts. So, it's kind of a moot point about what they do. They have to keep them tax-deferred. They have to pay all their tax if they take them out. And so, if they buy an income annuity with their tax-deferred product, it's irrelevant, the tax deferral is irrelevant. It's just going from the tax-deferred IRA to the tax-deferred annuity. What matters is that that money, whatever vehicle you have it in, is going to be taxed as ordinary income when it comes out.
So, you have situations where--just to walk through that again--you have situations where it's redundant, you have situations where there's another aspect of the annuity that makes it worthwhile having the redundancy, and then there's the idea that it doesn't really matter. You have to buy something. If you're going to buy an immediate annuity, say, it's just a way of paying you out. I think it doesn't really matter one way or the other, whether you buy that with tax-deferred money. Most people who buy those income annuities are going to be people who are middle income, and a lot of their money is going to be coming out of the qualified plans.
Now, the thing with the QLAC, the QLAC was amended in 2014 specifically by the Treasury in order to solve the RMD problem, because people wanted to buy annuities that started at age 80. They figured they'd live till 85 and that their money would last till 85 and they wanted to buy something, an insurance product, that would just pay from 85 for the rest of their lives, just in case they lived to 100. And that product could not be sold because the income started after the RMD period, so people couldn't buy it with their retirement assets. So, the insurance companies and the Treasury got together and said, OK, we're going to invent this thing called a QLAC, and you can put up to, it started as $125,000. I think it's higher than that. You can put up to $125,000 in tax-deferred money into this QLAC and have income start at age 80, and then you'll have to catch up with your RMDs thereafter. So, that's what a QLAC is. It's a deferred income. Deferred-income annuity is a very good idea for a lot of people. It's an overlooked product. But if you say I have enough money, but I don't have enough money if I happen to live that extra five years from 90 to 95, then you could for, not a very large amount of money, buy an insurance product that would pay you an income from 90 to 95 or 85 to infinity, and that's a very reasonable and very intelligent, often overlooked, way to use an annuity.
Ptak: Some advisors who otherwise might be inclined to recommend fixed annuities say they hesitate to do so because they can't buy inflation-protected versions. Why is that happening that inflation-protected fixed annuities have gotten scarce?
Pechter: Well, I don't know why this is such a controversy. I've been on email chains where experts in the industry go back and forth and argue about this ad infinitum, and I don't understand why they waste their time. You don't want to buy an inflation-protected income annuity, because the insurance company has to overcharge you so much to protect themselves against hyperinflation that you are going to pay a huge premium for that. And so, that income annuity is going to cost you a lot more at the outset. You might as well just pay for an annuity without inflation protection and take the money you saved that you didn't spend on the inflation protection and put it in the stock market and figure that if you believe that stocks for the long run and stocks as a hedge against inflation, then use it that way. Or just buy a booster annuity after five or 10 years so that picks up your income without an inflation adjustment. Anybody who gets hung up on that really doesn't know anything about annuities.
Benz: You keep a close eye on the annuity marketplace and write more about the topic than almost anyone else. What kinds of products are coming to market and which of them are consumers and their advisors buying?
Pechter: There are a couple of big trends. The hottest annuity going, not the most selling but the most year-over-year increases is in something that used to be called a structured variable annuity but is now called a registered index-linked annuity. It's a registered product. It means the security, so you have to be security licensed to sell it and an insurance agent can't sell it. It's basically a structured note issued by a life insurance company. Remember I told you about the people who walk into the advisor's office and say I don't know what to do, I have no idea what to do, help me? And it used to be that they would propose a fixed-indexed annuity, where you were guaranteed not to lose anything. But the much sexier, new version of that, like the convertible VA version of that, is the RILA. And the RILA is basically, it's an annuity where there are options that cap your returns--let's say, they cap your returns at 10% and they buffer your losses down to 10%. So, what you do is you buy this product – we just had a webinar on a line of ETFs that are defined-income ETFs and there are many others of those; there are quite a few companies are selling them now. AXA Equitable, when it was still AXA Equitable, invented them in 2010 or 2011.
And so, you buy the ETF and the issuer of the ETF takes the dividend yield from your investments in the index, in the stocks underlying the index, and he buys options and he buys some kind of put option at say minus 10 out of the money put and he buys a call option that buys up to a certain amount of the market. Or he can do it the other way and sell a call above a certain point or buy a put. There are different ways of doing it. But the important thing is that you have a collar that says you won't lose down to minus 10% and you can gain up to 10%, and a lot of people have said, wow, that is the perfect thing. The only thing you have to watch for that might end up as a nasty surprise, and I think it's not that big a danger, but it strikes some people as counterintuitive in the extreme is that usually they give a buffer, and a buffer is not a floor. A floor means you can only lose up to 10% and you can't lose any more than that. Most of these products, if the market goes down, if your ETF index goes down 5%, 7%, 9%, you lose nothing. But if it goes down 30%, you lose the net between minus 10% and minus 30%, you lose 20%. And the SEC kind of raised their eyebrows at that when it first came out, but they did nothing. And I thought people would balk at that, and the product has taken off. And that's one big development in annuities.
The other big development that people really need to know about, and we have not talked about this at all, it is the mastodon in the room, in the annuity world, is that low interest rates have been hurting life insurance companies--it's hard to overemphasize how badly this interest-rate environment has been. It's been as bad for insurance companies as it's been good for mutual fund companies. And it's the other side of the equation. And it has forced a huge restructuring of the annuity industry. A lot of companies--42%, for instance, of the indexed-annuity market is now held by companies like KKR, Apollo Athene, Blackstone. These are companies that have had to take over big blocks of annuity business and reinvest the assets in a way that supports them in ways that traditional insurance companies cannot by simply investing in government and corporate bonds. And this has changed the entire industry. So, in the future, to the degree that this continues, because we are going to see more and more of a migration of annuity products to these asset managers and they are risk-on people. This is something that I wouldn't expect the average person to understand right at the moment. You have to step back quite a few feet in order to see this happening. But we now have risk-on owners manufacturing a risk-off product, and exactly how they are going to accommodate that and what kind of products they will issue in the future remains to be seen. But you will still see the New York Life and The Guardian and the Northwestern Mutual, and say, a Principal issuing the income annuity. But you will never see any of these new owners--the Blackstone, the KKR, the Apollo--they will never be in the income-annuity business.
So, to that extent, it's been an outrageous decade for the annuity business. And the reason that you are finding that the products are so complicated is because in order to offer returns the insurance industries have had to use indexing. They have to tap into the profits of the stock market through indexing and options, because they can't deliver any returns through bonds. And that is what has made this business so complicated and so odd is that these insurance products have had to look like risk-off products and tap into the equity markets to get their returns. And they have had to twist themselves completely out of shape in order to do this. And the conversion from mutual companies to stock-owned companies--like around 2000 there was a wholesale transfer of mutual companies' demutualization to stock companies. And when they became stock companies, a stock company has to have very different set of returns, a different kind of flow of returns, a different level of returns than a mutual company.
And so, when a Prudential or a MetLife demutualize, their products changed. And when you go from a captive insurance pool to independent advisors, you have to start competing for them, and you have to start paying them higher commissions. Someday I will write a book about the whole process that we've seen from the mutual companies through demutualization, through stock companies, through the sell-off to the asset managers, and the impact that all of this has on the kinds of products that are manufactured, the kinds of advisors who sell them, and what kind of products those are exactly and for what purpose and the risk that they entail. And this is a great unwritten story, probably because it doesn't get anyone very excited. The insurance world is not very exciting. But to me, this has been an epic transition over the past 20 years that's quietly gone fairly unnoticed while people were celebrating the rises in the stock market.
Ptak: I wanted to ask about another kind of interplay, which is how the insurers' outlooks for the stock market and interest rates affect the provisions they tend to offer at any point in time. And I think that you've alluded to this interplay at various points during your comments, but did the participation rates on things like fixed-indexed annuities get reined in when stock market valuations are low and look richer when they're high?
Pechter: No, it's not the stock market valuations that determines the interest rate. Maybe I'm making a blunder here. But I believe it's all related to the interest rate, and that determines the caps and the participation rates. The interest rates and the volatility determine the cost of the options that the indexed annuities use to set their participation rates and caps. And when interest rates go down, they have a lower option budget.
Benz: If yields trend back up, as they have been doing very recently, how long will it take for that to be reflected in annuity payouts and other features?
Pechter: Overnight. It's interesting. There was one company, there was one mutual company that last March when bond prices dropped and yields momentarily spiked, there was one mutual insurance company that went out and just gorged on those low-priced bonds, and it was able to tear up the index annuity market in 2020, because they grabbed it and then almost instantaneous, it’s overnight, as fast as they can reprint the contract that would be reflected in the product, a month, say, would be the maximum.
Ptak: Maybe turning to due diligence on annuities. What's the best way to research the financial strength of an insurance company, or maybe a non-insurance company, prior to purchasing an annuity? Are there good free resources for this? Or do you need to subscribe to something?
Pechter: No. It's very easy to look up the strength ratings of an insurance company. It's on their website. It's readily available. You have four companies that rate them and the one that specializes in them would be AM Best--Fitch and Moody's and S&P all rate them, but AM Best specializes in insurance companies. The other place that I would go, because it's tougher on insurance companies’ ratings, is Weiss Ratings, that's Martin Weiss, and they do a pretty good job, a tougher job. It's harder to get an A from Weiss than from the others.
Your concern about the strength rating is going to depend on how long you are going to be holding this product. If you are only going to hold it for three years, if it's a fixed annuity or an indexed annuity that you're going to hold for just a couple of years, or a CD-type annuity, then it doesn't matter that much, and those products accordingly tend to sell on the advertised yield and the lower-rated companies offer, like a B company, would offer a higher yield. So, if you can get a higher yield from a B company over three years, you don't have to worry too much about them going out of business in those three years. But if you're buying a 30-year product, then you'd want to go with a company that's been around for at least 30 years. That's where you bring in the really big companies that have been around for 100 years. You'd probably want to go with one of those. So, I would say that it's product payouts that determine the shorter-term products, and then the longer-term products, you want to be with a completely gilt-edged company.
Benz: How do the state guarantee funds work to backstop annuity products? And should consumers feel confidence in these guarantee funds or be worried about them? Or does it depend on the state?
Pechter: Well, the payments vary from state to state. But the amount of insurance that you get varies from state to state. One of the first things you learn when you come into the annuity business, or it did to me when I started in at Vanguard, was that you are not allowed to mention, and when agents are selling them, they are not supposed to mention that there is such thing as a state-guarantee corporation and that's to prevent them from saying that, yes, the company has a D rating, but you're backed by its state, so don't worry. That's highly discouraged.
So, the thing that's important for people to know is that if they put say $200,000 into an income annuity where there is a contractual obligation set in stone for them to get their money for their life, they have a very strong chance of getting all that money back. But there is some ambiguity about these lifetime income-guarantee products, that if you buy a variable with a, as I mentioned, liquid lifetime-income guarantee, there is some question about whether that lifetime-income guarantee, because it's contingent, it's just not looked upon the same way. Those "living benefits," they provide lifetime income, but they are not looked at in the same way as income annuities. And that's really a moot point, because the companies that sell you the income annuities are not the same companies that are going to be selling you the variable annuity with lifetime benefits. So, very few people are going to have to choose between one of those two. But I would say that if you have bought the income annuity, you're on the firmest possible ground regarding being backed by the state. There is a national organization called NOLHGA, I think it is, and you can find out a lot about the state-guarantee corporations or associations there.
Ptak: I wanted to close by asking about the retirement system. Anybody who covers the retirement landscape, as you do, has to be struck by how complicated it is to generate income in retirement. Can you think of any ways this might all be simplified?
Pechter: Well, it's always a matter of liquidity versus the guarantee. And the reason that it's difficult to simplify is because each retiree is almost like a different plan. It's very hard to standardize a retirement income plan, because it pulls in everything. It pulls in your liabilities-- your health liabilities, your dependent child liabilities--and all your assets, your house and for people who are on the margin, all of these things have to be considered. And it takes some creativity to adopt the retirement plan. The simplest approach, when we're not talking about Social Security, is just to figure out what it's going to cost you a month to live, figure out what you're going to get in Social Security, take the difference and then you have to think about how can I make that difference. How can I bridge that gap in a way that's palatable to me and that gives me the protection from risk that makes me feel secure so that I'm not sitting there watching CNBC every night and wondering whether I'm going to run out of money when I get older.
So, the plain-vanilla and chocolate method is just to take Social Security plus another source of guaranteed income. You can buy an annuity if you don't have a pension, and then put the rest of your money in equities, and then sleep easy at night. On a personal level, that's the simplest way to approach retirement.
Benz: Well, Kerry, we've learned so much from you today. Thank you so much for taking the time to be here.
Pechter: The pleasure was all mine.
Ptak: Thanks again.
Pechter: Take care.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
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