Using Annuities to Mitigate Risk
The Retirement Income Journal editor Kerry Pechter tackles common annuity misconceptions.
Editor and publisher of the Retirement Income Journal and author of Annuities for Dummies and two other nonfiction books, Kerry Pechter unpacked annuities and addressed how they fit into the retirement income puzzle on Morningstar's The Long View podcast.
Generating income in retirement can be a knotty topic; Pechter tackled common annuity misconceptions and broke down some of the most popular products, outlining a few situations in which purchasing an annuity could be beneficial.
Here are a few excerpts from Pechter's conversation with Morningstar's Christine Benz and Jeff Ptak:
Ptak: 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 this distinction is breaking down a bit? And if so, why is that happening?
Pechter: Well, here at the Retirement Income Journal, 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 a risk transfer away from the individual.
Investments are 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 come 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 are a couple of answers to that. 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.
This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.
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