Many investors avoid annuities for a variety of reasons, including high costs, surrender charges, and complicated structures that often make it difficult to understand exactly how the annuity will perform under different market conditions. As the first part of this article discussed, although recent innovations within variable annuities reduce some of the market risks associated with them, these new features come at even higher costs. However, Moshe Milevsky, a finance professor at York University, recently presented research that suggests that the costs of these features aren't high enough to compensate insurance companies for the risks they assume.
Comparing annuities and derivatives
Professor Milevsky's research focused on the guarantees of minimum withdrawal, accumulation, and income benefits that many variable annuity contracts now offer investors. In order to analyze whether or not insurance companies were charging an appropriate fee to investors for these options, Professor Milevsky sought to determine what other types of financial instruments provide similar protection to investors.
Most of the options offered to annuity investors are designed to reduce downside risk over the long term. Whether a given benefit focuses on the value of the investment itself or the income that can be generated from the investment, the guarantees offered by insurance companies all seek to give investors assurance that no matter how bad things get, they will receive at least a minimum amount of money back from their annuity holdings. The way in which the insurance company guarantees a minimum value for the annuity is similar to the way in which an investor who owns a put option on a stock can exercise the option and sell the stock for a fixed price, even if the current market value of the stock is much lower than the option price.
Because put options are available both on publicly traded options exchanges, as well as through private transactions by financial institutions, it should be possible to create a combination of put options that provides the same guarantee that these annuity features offer. When Professor Milevsky determined an appropriate alternate hedging strategy and inquired as to how much it would cost to buy it in the derivatives market, he discovered that the prices that insurance companies charged were much lower than the cost of buying equivalent derivatives. For example, the true cost of a guaranteed withdrawal rider, for which insurance companies typically charge between 0.3% and 0.5%, could be as high as 1.6%. With prices so far out of line, it's likely that insurance companies are not hedging against the full risk of a sustained downturn in the market.
Assuming longevity risk
In addition to market risk, the options offered by insurance companies often increases their exposure to the risk that annuity owners will live longer than mortality tables suggest. Historically, most annuity owners never elected to receive payments over their life expectancies, and so insurance companies didn't actually take on longevity risk. However, with increasing attention to the benefits of locking in regular income during retirement, it's likely that more investors will decide to annuitize, increasing the risk that insurance companies will bear as a result. If life expectancies continue to increase as they have in past decades, then insurance companies may face much higher payouts than their actuarial models initially suggest, creating a profit crunch in the future.
Furthermore, some of the benefit options now available on annuities encourage annuitization by owners. Guaranteed minimum income, for instance, can be a huge incentive for annuity owners to annuitize. If these guarantees are triggered, moreover, the insurance company may face substantial risk if the owner lives well beyond his or her life expectancy. Professor Milevsky points out that a large British insurance company nearly failed as a result of taking on too much risk.
Caution for investors
While you likely won't see signs of cracks in the foundations of major insurance companies like American International Group
Moreover, just because the add-on charges for these optional features may be too low doesn't mean that the overall level of fees for annuities isn't high. On average, investors seeking exposure to certain asset classes can find less expensive vehicles, including mutual funds and exchange-traded funds, to put their money. Previous studies, including one by Professor Milevsky himself in 2001, have concluded that higher fees and unfavorable taxation of annuities outweigh the advantage of the tax deferral within annuities. Those who want annuities in their portfolios should consider the lower-cost offerings of companies like Vanguard, Fidelity, and T. Rowe Price
If anything, Professor Milevsky's research presents an unsolvable dilemma for annuity investors. If insurance companies charge the full cost of the benefit options they provide to investors, then costs will rise even further. On the other hand, if investors get a bargain by paying lower costs than they should, then they still bear the risk that their insurance company will overextend itself and be unable to repay annuity contracts as they come due. When it comes to annuities, the best advice is to tread carefully.
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