By Bill Broich
Guarantees or a future guess, which would you choose?
Annuities are annuities, right? The term annuity when used as a noun can mean two entirely different products.
According to Investopedia, the definition of an annuity is: An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time.
In actuality, an annuity can be many things, it can be an accumulation product, it can be an income source, it can be an insurance product and it can be a security product. An annuity can be a wide array of many different things. An annuity contract can be both for a period of a few years or a contract providing benefits for lifetimes. It is adjustable and it is flexible.
An annuity can be fully guaranteed or it can base its future on future market risk. The difference is which annuity we are speaking about.
There are two basic categories of annuities:
- Those sold as insurance products
- Those sold as investment securities.
Annuities sold as insurance products have no fees, have guarantees and have no market risk. An insurance annuity will provide contractual guarantees. These guarantees promise what the minimum value of an annuity will be at any future date, it will guarantee exactly the guaranteed income will be at any future date.
An annuity issued by an insurance company may also fully guarantee and interest rate that will be used to determine the guaranteed value in the future that income will be based on. It will also guarantee in the contract the “factor” that will be used to determine exactly how much income will be available at any yearly time period. This important “factor” is essential because it only exists in annuities issued as insurance products.
The reason? Insurance annuities are state of residence specific and are regulated at the state level by the individual state department of insurance. State insurance departments demand that everything be guaranteed in the contract, nothing is based on future guesses. Insurance annuities are guaranteed by the insurance company to never lose value and to never participate in market risks.
The other category of annuity is a variable annuity, and while it is technically issued by an insurance company, it does not come under regulation by each individual state department of insurance, it is regulated as a security by the Securities Exchange Commission (SEC). This type of annuity is not an insurance product, it is a security and those that invest in this category of annuity are investing in the securities market. A variable annuity can increase in value and it can decrease in value.
Variable annuities have fees and expenses, fees for the contract, fees for the management of investment, fees for enhanced policy benefits such as income riders.
The SEC publishes information and warnings regarding variable annuities, here is a link for more information: https://www.sec.gov/investor/pubs/varannty.htm
Variable annuities can also provide income that is based on a level of guarantees. Many variable annuities offer interest rates as high as 6% for any fund which will be used as income.
What is the difference between income from a variable annuity issued as a security and income from an annuity issued by an insurance company and state regulated?
Both will offer a fixed and guaranteed interest rate which will be used to determine the income formula, annuities offered by insurance companies will also guarantee the “factor” used to determine the actual income. Variable annuities do not offer a guaranteed “factor,” instead they use a formula tied to numerous future events. This future “factor” should be considered a derivative.
Here is a definition of the word derivative:
- something that is based on another source. An arrangement or instrument (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying set of circumstances.
Why do variable annuities use a derivative to determine future income? Simple, this method allows for the insurance company to hedge their exposure to the long term liability of a long term income responsibility. In other words, the future event will never allow the variable annuity company to be exposed, the “factor” actually used will always benefit the insurance company.
How could 10% fully guaranteed for funds used to calculate the income accumulation be less available money than a similar product offering far less guaranteed interest?
Simple: the factor used to actually determine the income will be lower, it is all smoke and mirrors. It makes no difference how much interest is offered because the only financial calculator that makes a difference is the “factor.”
With guaranteed annuities, the factor to determine actual income is contractually guaranteed. In variable annuities, the “factor” is a derivative, it actually depends on what happens in the future.
Guaranteed or a derivative, which would you use to base your future important income on?