The story goes like this: An economist and his friend are on a hike; dark clouds appear, and rain is certain. The friend says to the economist, “it looks like rain.”
The economist looks at the dark sky and says, “well then, let’s assume we have an umbrella.”
When you examine the economist’s remarks, it paints an obvious picture of how many people look at the future: in assumptions.
We have all seen this: “Past Performance Is Not Indicative Of Future Results.” This statement is at the bottom of stocks and bond ads, mutual fund ads and variable annuity ads. What it says is this: Take your chances!
One of the biggest abusers of future assumptions are the companies that provide a specific retirement product: Variable Annuities.
Unlike annuities provided by insurance companies and sold as insurance products, Variable Annuities are securities sold via a prospectus by security salespeople.
The assumptions Variable Annuities use are hidden behind guarantees. How can a company offer guarantees and then use assumptions? It is accomplished link this: The Variable Annuity provides a guaranteed annual rate on all deposits IF the annuity owner uses the funds for income as specified by the contact. Often the guaranteed rate of interest offered could be as high as 6% compounded annually. Sounds too good to be true, in fact, it is true; they will happily guarantee you the interest rate on funds used for retirement income calculation.
6% no problem.
How are they able to offer such a high rate of interest?
The annuity owners “income” account grows at 6%, at the time of retirement, the Variable Annuity company via an actuary prices the actual payout based on the value of money, primarily the value of US Treasuries.
Tip: Funds invested in a Variable Annuity are not actually at the Variable Annuity company. The funds are being invested in “separate” accounts with fund managers; these accounts are very much like mutual funds.
Once an annuitant decides to execute the income option, the funds are returned to the Variable Annuity company, income valuation is priced based on US Treasuries, and THE income is calculated. The Variable Annuity will also make a profit on the payout and based on the amount of income paid.
The interest rate credited for the accumulation phase is of no real value, it is all based on the actual value of money at the time of the income selection.
Brokers selling Variable Annuities will use an ASSUMPTION when selling the contract initially, but that is all it is a guess.
It is not until the actual decision is made to use the Variable Annuity as income that the amount of monthly income being received via the contract is calculated.
There are two massive differences between annuities sold as an insurance product and annuities sold as a security product.
- Variable annuities live on assumptions; insurance annuities live on guarantees. Guaranteed interest rates, guaranteed income factors, the annuitant can know precisely at any date in the future what the guaranteed income will be.
- Funds on deposit in variable annuities are subject to fees, expenses, and market risk. Funds on deposit in an insurance issued annuity have no fees, no expenses, and no market risk exposure.