A Case for Annuities
“If what you seek is truth, there is one thing you must have above all else…an unremitting readiness to admit you may be wrong.”
…Anthony de Mello
I have often said that while there are wrong ways to invest, there is no one right way. Part of that little bit of philosophy is the realization that things change over time.
For years I used deferred annuities very sparingly. A deferred annuity is an account with an insurance company into which you deposit money today, either in a lump sum or by making regular premium payments over time, in order to accumulate money for retirement. I was convinced that there was more potential for portfolio growth using other vehicles. While that remains true, I have changed my attitude about annuities. Let me tell you why.
The stock market, goes through cycles known as bull markets (periods of growth) and bear markets (periods of market losses). I see a number of risk factors in the economy today which, I believe, make it more vulnerable to longer and more severe bear markets than what I have seen in the past. Keep in mind that saying there is a risk that this will occur is not a prediction that it will occur. If I am traveling along I-5 from Seattle to Los Angeles, I am taking more of a risk if I take that trip on a Harley Davidson than I am if I am driving a Cadillac Escalade. That doesn't mean I don't expect to arrive safely on a Harley, but I will want to wear a helmet (and have my life insurance premiums paid current).
In the late 1990s the stock market was on a tear. Everybody was a genius at investing. You could do no wrong. The S&P 500 was up over 20% each year between 1995 and 1999. Then it fell. Down 9.03% in 2000, down 11.85% in 2001, down 21.97% in 2002. At the end of 2002 the value of the S&P 500 was 62.57% of what it had been at the end of 1999. That was followed by several consecutive years of growth to be followed by 2008 in which the market lost over 1/3 of its value. If you were invested in the S&P 500 in 1999 and remained invested (nobody earns exactly what the index earns because of trading costs among other things), it would have taken you until 2006 to make back all of your losses. Then two years later you would have seen your account balance fall below your 1995 levels and not recover until 2010, and you would not get back to your 2007 level until 2012. And that doesn’t even deal with the reality of the fact that most investors don’t have iron wills, and tend to make investing decisions that cause them to underperform the market.
The national debt, at over $17 trillion, is higher than it has ever been, even when you account for inflation. Just the interest on the national debt in 2013 was over $145.5 billion. And interest rates are the lowest that most of us have ever seen in our lifetimes. As interest rates rise, that national debt and the interest paid on it, only gets larger. The appetite to do what it would take to lower that debt doesn't seem to exist in Washington D.C. All that money being spent by the government means less money available to be spent by the private sector of the economy and slower economic growth. And you need economic growth to generate the taxes to pay the debt. It becomes something of a vicious cycle.
We have emerged from what has come to be called "The Great Recession". The problem is that the technical recovery has been slow and lackluster. Generally speaking, a recession has the seeds of its own recovery built in. When people drive cars longer and put off buying things they need, those necessities build up demand which spurs economic growth and a recession has a tendency to heal itself. This recovery though has not been as dramatic as the recession was.
Unemployment is high, and the official numbers underestimate the reality. The unemployment rate is derived from the number of people collecting unemployment insurance. If somebody takes a part-time job, or gives up looking, or takes a job paying less than they are accustomed to earning, they drop off the unemployment rolls. The statistics don't allow for those factors. So as of August 2014 the official unemployment rate is 6.2%. According to Shadowstats.com if we were to take those factors into account the rate would be closer to 23%!
Inflation is a deceptive thief. It may look like you have the same amount of money to spend as you did last year, but that money buys less. The government uses the Consumer Price Index (CPI) to measure inflation. Among other things, it uses that data to index tax rates and provide cost of living adjustments for government employees and payments, like Social Security and government pensions. The problem is that the Bureau of Labor Statistics has changed the way they have calculated the CPI over the years. The official inflation rate as of June 2014 was 2.1%, meaning that goods and services cost about 2% more in June of 2014 than they did in June 2013. According to Shadowstats.com, if they were calculating inflation today the way they did in 1980 that rate would be about 10%.
I have referenced Shadowstats.com twice now. I don’t want you to get the idea that I rely on that website as the definitive source for truth. There are other financial writers who question their methods of analyzing government data and oppose some of the views expressed by Shadowstats.com. The point I am making is that there are different ways of looking at these things, and some of them make our economic situation look more tenuous than others.
The Nobel Prize winning economist Milton Freidman has said that, “inflation is always and everywhere a monetary phenomenon”. He also said that he had never seen a sustained increase in the money supply that was not followed by significant inflation. For several years the Federal Reserve has been pumping large quantities of money into the economy and keeping interest rates low. They believe they can reverse course in time to head off inflation (at least the way they have been measuring inflation). They may be right. But if Milton Freidman was right, we are in for a shock to our cost of living.
Health care in the United States is a significant cost for most of us. For many others it has been unavailable, because of the expense. In 2010 Congress passed the Affordable Care Act (ACA), sometimes referred to as Obamacare. The idea was that it would solve the affordability problem. It has been being implemented by increments over time. There have been a number of significant problems with that implementation and it has been widely unpopular. There are reports of businesses laying off workers or cutting hours to part-time to avoid having to adhere to some of the provisions of the ACA. Individuals have reported dramatic increases in premiums and deductibles or having their insurance cancelled altogether. Regardless of your position on Obamacare, there are some serious questions as to whether it will solve the healthcare problem and to what extent it may have a negative impact on the job market and the economy.
Then there are international uncertainties that can ripple through the world economy, looming insolvency of Medicare and Social Security, the retiring baby boomers…
Let me reiterate. This is not a prediction of gloom and doom. There are also reasons to believe we will be just fine. When I give examples of the threats to the economy and make a general statement that I'm not predicting disaster, that juxtaposition leaves a greater impression of the dangers than the positive things. So let me mention a few of the reasons to believe our economy could be resilient and may continue to thrive.
Stocks are commonly valued on a price to earnings ratio, that is how many years of expected earnings will it take to earn back the current price at which the stock is selling. Over the last 25 years, according to SeekingAlpha.com, the average P/E ratio of the S&P 500 has been 18.9. As of August 18, 2014 the P/E ratio of the S&P 500 was 19.55. That is pretty close to the average. Between August, 1989 and the end of July 2014 (approximately the same timeframe used to derive the 18.9 P/E ratio) the S&P 500 with dividends reinvested had an average annual return of 9.515%.
The fact that the recovery from the last recession has been slow and shallow, may indicate that it will be a more sustained recovery than average because it is not burning up its fuel.
Technological advances and the US participation in the global economy support a positive outlook for the market.
The energy boom within the United States, provides insulation from turmoil in the international energy markets and gives us some ability to distance ourselves from the instability in the Mid-East. It is a potential for good paying jobs and abundant energy supports domestic businesses.
Companies are beginning to bring jobs back to the United States that it had previously sent overseas.
Just as there are more reasons for concern than what I have listed there are also more reasons to be optimistic. So while I feel more like I am riding a Harley to LA than an Escalade, I am perfectly willing to enjoy the ride. Given all that, why does this argue for an annuity? Because I think it is folly to invest on the assumption that your assumptions are correct. None of us can know what scenario will play out.
Although you can take your money out of an annuity in a lump sum, they are designed to provide an income stream. Many modern annuities have a feature that provides asset protection if you withdraw your money out of them over time. These annuities will guarantee that the amount you can withdraw from your account will increase by a certain amount each year for either a given number of years or until you begin making withdrawals, provided you stay within a formula that is designed to provide income over your lifetime. If your investment account grows faster than the guaranteed increase, these products increase your guaranteed withdrawal amount in line with the higher growth rate of your account. So when the market goes up, your ability to make future withdrawals increases. When the market goes down, or remains the same, your ability to make future withdrawals still goes up, but at a slower rate. Keep in mind that all guarantees are based on the claims paying ability of the underlying insurance company. Because of this benefit, you may find yourself in a situation where you continue to make withdrawals from an annuity even when the account balance no longer supports those withdrawals. Each product has their own way of calculating these benefits, but that is the gist of it.
This benefit isn’t free. There is a cost for that provision, as well as limited investment selection. Annuities often have surrender penalties lasting several years and the costs associated with the annuity itself may be higher than other investments. In a Variable Annuity, your actual account value, that is the amount you can withdraw in a lump sum, may decrease in value. In an Equity Indexed Annuity, the growth in any given year may be capped. So I would not expect a deferred annuity to have the same growth potential as some other investments. On the other hand the cost of that greater growth potential in those other investments is the risk of losing some amount of value in your account. The answer isn’t to put all of your money into an annuity. But I have come to believe that it is appropriate to put some amount of your nest egg in an account that amounts to wearing a helmet when you are riding motorcycle.