Are Annuities Really So Terrible?

A friend of mine was pitched a variable annuity. He sent it over to me to take a look.

Before I get into the details of this product, I want to make clear two things: I am not an expert in this field, and there are more annuities than there are hedge funds. They all share some basic characteristics, but the devil is in the details.

This particular variable annuity was linked to the NASDAQ 100 and S&P 500 with specific caps to the upside and buffers to the downside.

This illustration shows a hypothetical deposit of $1,000,000 at the end of 1988. After the 10th year, the person could have pulled $222,987 out every year.

A few observations:

1- Had this person invested the $1,000,000 in 1989 in a 60/40 portfolio, they could have taken out the same $222,987 annually and be left with $2.3 million, three times the value of what remained in the annuity.
2- Had this money been invested in a 60/40 portfolio, to be left with the amount of money at age 72 that was in the annuity contract, they could have taken out ~$310,000, or an additional $1.1 million over the 13 year period. (I was only sent pages 6-14, so I don’t have years 2012-today, which if anything would make this annuity look less attractive given the market’s performance).

Okay, so obviously the person would have been better off investing the money in the market but this definitely deserves a few caveats:

  • Nobody knew what the market was going to do over a 23-year period starting in 1989.
  • Even if they had the long-term, low turnover mentality, could they have stayed the course during the internet mania and the popping of the bubble? Could they have stayed the course during the great financial crisis? Could they have stayed fully invested this entire time without touching their account even once? Highly unlikely.
  • The growth of the 60/40 portfolio is gross of fees, the annuity is net of fees.
  • Finally, this contract would have allowed somebody to receive $2.9 million in income (partially taxable), and still have a $778,965 death benefit, not so terrible.

It’s unlikely that an annuity will do better than the market, given that there are costs associated with the insurance, but it’s also unlikely that somebody can invest without any frictions or behavioral lapses over a multi-decade period of time.

There are terrible annuities like there are terrible investment products, but maybe they’re not always terrible an option as they’re often made out to be.