As a fee-only financial adviser and fiduciary, much of what I do at Define Financial involves unwinding new clients from the garbage they were previously sold by commissioned salespeople. (Naturally, I have a strong opinion about this!) Sometimes, this means trying to figure out how to get a client out of a non-traded REIT. Other times, it means figuring out if it makes any sense to keep a variable universal life insurance policy in place.
Recently, I had the opportunity to analyze several annuities for different clients. My conclusions yielded what may be a helpful rule of thumb for analyzing future annuities:
“Annuitize for today. Surrender for tomorrow.”
Surrender for Tomorrow
As a fee-only financial planner, I live in a world where annuities are not only frowned on, but actually made fun of. That is, when hanging out with a group of like-minded fee-only fiduciaries, a joke will be made more than once about what poor financial products annuities are for clients. (Usually, it’s me making the joke!)
And the humorous critique is justified. Because of either the high fees or the limits on growth, it usually makes little sense to put money into an annuity. This idea is even more applicable as the complexity of the annuity product increases. That is, while a single premium immediate annuity (SPIA) may make sense in certain circumstances (because of the low fees involved), more complex annuities such as variable annuities, are rarely a helpful solution.
For this reason, the common approach taken by fee-only advisors billing via AUM to creating a client’s financial plan is for that client to roll over any existing annuity product into a low-cost, globally-diversified investment portfolio. Over time, the growth available via a low-cost investment portfolio will outpace the growth available in a complex annuity product – despite any surrender fees that a client may have to pay for exiting said complex annuity product.
(future portfolio value – surrender fee) > future annuity value
In short, for a fee-only fiduciary, the gut reaction when seeing an annuity is to get the client out of it. (Naturally, there may be a conflict of interest here if that adviser is billing for a percentage of assets under management.)
Annuitize for Today
While it usually makes sense to surrender an annuity if a client has a long timeline, the opposite may be the case if the client has a short timeline until distribution. That is, if a client is retiring today or in the very near future, then it may make more sense to keep the annuity in place – and annuitize for cash flow. This makes sense if the client has a need for cash today. If the client does not need money in the near future, then investing the surrender value of the annuity may be appropriate.
The reason why it sometimes makes sense to annuitize an annuity instead of surrendering it is because the annuity company may just offer an annuitization rate that is more favorable then what a low-cost investment portfolio could provide in terms of a sustainable distribution rate. In a recent example, I was analyzing a client’s annuity with MetLife / Brighthouse. Due to the client’s age, a roughly 10% distribution rate was being offered by the annuity company. Especially considering the client’s relatively conservative risk tolerance, there was no way an investment portfolio would be able to generate a similar level of sustainable distribution.
The one caveat with this approach is that annuitizing an annuity will only be a successful strategy if said annuity company stays solvent. This is why checking a company’s credit rating should be a consideration in your analysis. (The same can apply to pension solvency.)
Rule of Thumb for Annuitization
In conclusion, consider annuitizing an annuity if the annuity company is offering a favorable annuitization rate for clients who need immediate cash flow. For those clients with a longer timeline, surrendering an annuity and investing the proceeds for future growth in a low-cost diversified portfolio may make sense. Of course, running the precise numbers is always important to determine which strategy is best for the client.