Wednesday, April 7, 2010

Background notes: Annuities, Retirement Plans, and the Government

After seeing comments by Burgess Laughlin on my earlier post about the Treasury request for comments on “life-time payments”, I realized that there were some underlying history and understandings that I had not included. This background is not general knowledge and it would be helpful, I think, for this information to be available. This is not a research paper. I am not including references and quotes from “authorities”. I am giving you my understanding of the situation, which provides some of the foundation as to why I came to the conclusions I did in the earlier post.

Annuities are one of the oldest financial products. Originally, an annuity was purchased when a person was ready to receive an income stream. It is purchased from an insurance company because the insurance company has the expertise in computing life expectancy and using long-term, incoming producing assets. When purchased, the life expectancy of the person to receive the income was computed, the current interest rate considered, and the income stream is determined. The income stream continues for the entire lifetime of the annuity owner. Some owners die early, some late. If the insurance company has made good life expectancy computations over sufficient number of owners, it will be able to meet all lifetime payments and make money.

Two things have changed over the years. One, annuities became tax shelters. You can purchase what is called an annuity without beginning the income stream, or as it is called today, annuitizing it. The interest rate may be fixed at purchase, or the interest rate may be adjusted before annuitizing as the market changes. The interest rate is not adjusted after the income stream is begun. When you purchase the annuity and don’t begin the income stream, it accrues interest, that is the principle grows, deferring income taxes until the income stream begins. Actually, there is no requirement that you begin the income stream. You may withdraw cash as you wish from the annuity until it is all withdrawn, and will have some taxes to pay. Under current law, if you withdraw money prior to 59½ there will be an additional 10% tax penalty. If you annuitize it, you will also pay taxes on the growth.

The other development is the creation of “variable” annuities. After hearing severe criticism that interest-bearing vehicles provided poor returns, the insurance industry created annuity vehicles with “sub-accounts” that were similar to stock and bond mutual funds. The poor returns of fixed annuities are actually worse than most critics argued. After internal costs, i.e., the insurance company’s costs and profit margin, taxes, and inflation, the return on an fixed annuity tends to be negative. Variable annuities are almost identical to what were now called fixed annuities in tax treatment and structure, but their return was based upon the results of the stock and bond sub-accounts that the owner selected. Of course, as opposed to an interest bearing account, returns based upon stock or bond markets might show declines in the principle. Some insurance then added optional benefits to variable annuities to try to overcome some elements of the potential negative return, adding costs and complexity.

After the tech stock crash ten years ago, another type of annuity gained popularity called the indexed annuity. Its return was tied to a stock market index, but did not actually contain stocks. The returns were lower than the market to allow the annuity company to engage in hedged trading to counteract equity market declines. An owner could have higher return than a fixed annuity but not have the fear of the declines in the stock market.

Annuity products came under attack from several quarters. It was claimed that annuities themselves had higher internal costs than they needed, and thus the insurance companies were making too much money at the publics expense. Since these products were offered to the public through normal sales channels that insurance companies used, it was claimed that salesmen were taking advantage of the public to earn huge commissions, especially when the owner was elderly. Finally, it was argued by the Federal Regulatory authorities as well as others that placing an annuity within a retirement plan or IRA was often a bad idea because the retirement plan already deferred taxes, so a major reason for purchasing an annuity before retirement was not applicable and were sold within retirement accounts only to earn the insurance companies excessive profits and salesmen huge commissions. (Regarding some of these accusations, it is true that that some of the products offered on the market had excessive expenses and commissions.)

Thus, for the federal government to now suggest that annuities are important and to suggest that they should be a required option in a retirement plan is a complete change.

What is interesting is not just that there seems to be a change in attitude, but where this change is taking place.

There is no part of the federal government that concerns itself directly with the retirement income of individuals. Even with Social Security, the administration only follows the law. It is the Congress that has had some concern over the years, putting in place various tax-advantaged options as incentive to retirement savings.

You might say that the Treasury has some connection with pensions because its responsibility for pensions paid to retired government employees. Actually, there is no comparison. The only similarity to a federal government pension and that paid by any other organization, including, I believe, state and local governments, is that the recipients are retired. The federal pension is financed in the same manner as Social Security, that is, it is paid from current revenue. In addition, federal pensions are indexed to inflation. Pensions paid by others are funded at retirement and placed in annuities, which is a lifetime stream of income at a fixed rate of interest. The Treasury doesn’t have to concern itself with the funding, just the cash flow.

Three government agencies have interests in tax-deferred retirement plans: the Labor Dept., the IRS, and the SEC/FIMRA (was NASD). The interest of the Labor Dept. is to ensure that lower level employees are treated the same as the managers (e.g., upper management is penalized if the lower level employees don’t contribute sufficiently to defined contribution plans). The IRS is responsible to make sure that regulations are complied with to maintain the tax-deferred status of the plan. The SEC and its little “independent” regulators oversee the compliance with security regulations if securities are offered within the plan. The system has no governmental body that is concerned with the success of a plan or the decisions of the employee during their work years or retirement.

Now the Treasury is leading such an effort. Not the Labor Dept., although it seems to be tagging along with the Treasury. But why is the Treasury involved at all?

There can be only one connection. One of the primary investments for fixed annuities for the insurance company is “safe” government bonds. Insurance companies don’t use only government bonds, but it is certainly a major component. If a significant number of people began buying fixed annuities, the market for government bonds would expand.

If you look at the questions for which the Treasury wants answers you will see a concern about the costs of annuities. My expectation is that they will find that using private insurance company fixed annuities would be too expensive. This conclusion fits with the anti-business philosophy you find in many different parts of the economy, the financial sector, and the current administration. They want to cut out the middlemen, including the salesman and the profit seeking business. As with the justification for removing funding of college tuition, they would see supplying government created annuities as a cost savings to the retiree. They would also be able to fund the annuity entirely with government bonds.

So, as a result of their “studies and analysis” they would ask the Congress to allow the creation of government annuities and require all employers above a certain size who have 401(k) retirement plans to offer the annuities for “investment” or for an income stream at retirement. Then, brick wall. You see, offering them and not selling them will not have the results the Treasury is expecting. Few people will buy annuities, even with the government backing. Certainly any advisor, money oriented writer, or publication will point out the complete lack of benefits for the buyer.

No. If the Treasury wants to see bonds sold to retirees in the form of annuities, they will have to require the bonds to be “bought”. It isn’t going to happen any other way.

That is why I say that the Treasury is going to grab retirement accounts. That is why I am concerned. That is why I wrote the post I did.

This process may take a couple years. It might not come to pass. There are certainly many obstacles that stand in the way.

But if they could sell ObamaCare, they can sell this. If they can legally require people to buy health insurance, requiring them to buy annuities to keep them from needing welfare in later years will not be a big jump. All the government wants to do is to “assure” retirees that they will have an income for the rest of their lives. It is the same type of justification that Obama has used for other intrusions into our lives. It is in line with the justification for Social Security. If it can be done, I am sure that Obama and his Gang can figure out all the buttons to push to get what they want.


  1. I read your article it's really Nice article on Annuity,have some very good points in addition to this i want to discuss some more points regarding Annuity ::-

    1. It is just and natural that every employee saves some money for his future.He has to invest these savings so that after his retirement,he gets some money every month which he can use for his day to day needs.

    2. Annuities can be structured in a number of ways; varying accumulation period, length of income payments and other factors.

    3. Annuity payments are taxable payments. On each monthly payment you receive you will be held responsible for paying a tax on it.

    4. Ways to sell annuities :

    1.Other pension.
    2.Security for a loan.
    3.Big purchase.

  2. As a private individual, planning for your own retirement, an annuity could play a role. You can, if you want to spend the time or hire a professional, come up with schemes that enable you to shuffle things around. What you cannot easily do is cover for inflation. Elsewhere, rational_dave has pointed out that fixed annuities are available with some features that help. The downside is that these added features come with added expense (as they should) and thus cut into the initial rate of return. Other options may be available, for example, having money in other non-fixed investments to provide additional cash to overcome inflation. However, that only works if the inflation is low, say 3% or less.

    Right now, the problem with using a fixed-annuity (and perhaps a variable one, too) is that we don't know what the intermediate future holds. Because of the deficit, government spending, and the Fed's actions, we could be facing significantly higher rates of inflation. If that is so, having money tied up in a fixed-income vehicle would be a disaster. Selling it to a secondary market would not be a good solution because the market would not offer face value, but one discounted to accomodate the low interest in the annuity compared to inflation. As with bonds, right now, annuities are a risky place to be.

  3. @ CW - I think this is a pretty fair assessment of annuities, overall. I would not agree 100% on some of your conclusions, but I think the general idea is correct.

    It is tough to deal with inflation. There aren't a lot of financial products that have done it well. I think assets like precious metals do a decent job.

    Some stocks are good (if you are concerned with income), and a good quality dividend-paying whole life contract generally has been able to compensate somewhat for inflation because of the dividends (the only problem being it takes a LONG time for those contracts to show positive returns as available cash which makes them great for long-term, not so great for short and intermediate-term).

    Of course, ending the debasement of our currency would certainly solve the problem.

    - rational_dave

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  5. C.W., thank your this valuable and intelligent insight on annuities. It certainly helped me when understanding the current economy and needing a place to invest in Fixed Annuities.