I love the game of blackjack. When I sit at the table, I feel optimistic and in control. However, as time goes on, I start betting larger amounts resulting in more risk. At this point greed takes over and I believe nothing can go wrong. We all know how this story ends though…
To no surprise, it’s not uncommon for blackjack winners to keep playing in the hopes of winning even more. Walking away is an important decision if you want to maximize profits and minimize losses. While investing in the stock market is fundamentally different from playing blackjack, drawing a connection between the two can provide interesting insights.
Both the stock market and blackjack involve risk and uncertainty. In blackjack you make decisions based on limited information, only seeing your own cards and the dealer’s up card. Similarly, investors in the stock market face uncertainties about future market movements, company performance, and economic conditions. Just as managing your bankroll is crucial in blackjack to extend playing time and minimize losses, investors in the stock market practice portfolio management and diversification to protect their investments and minimize risks. Further, both blackjack and the stock market exhibit variability in outcomes. In blackjack, winning or losing streaks can occur due to chance and the changing distribution of cards. Likewise, the stock market experiences periods of growth, decline, and volatility that can affect investment performance.
When it comes to variable annuities, these instruments which are directly exposed to the stock market can be a reliable asset in a retirement portfolio. However, they come with drawbacks such as excessive fees and the potential for account erosion. On average, variable annuities charge around 2.3 percent per year in fees, but this can exceed three percent depending on the policy. These fees are deducted from your balance annually. Considering recent market downturns, it is worth considering “locking in gains” to protect what you have earned and avoid potential losses.
In this article, I will explain why individuals should consider upgrading their variable annuity policy by adopting a flight-to-safety approach. This approach involves moving capital from riskier investments to safer alternatives during times of market volatility or economic uncertainty. One strategy that aligns with this approach is exchanging a variable annuity policy for a fixed indexed annuity policy. This change allows for wealth generation and lifetime income without the risk of capital loss. While variable annuities excel at generating a rate of return, they fall short in generating lifetime income compared to alternative annuity vehicles. Let’s take a look at both the benefits of switching to an indexed annuity policy and the potential drawbacks.
Benefits of Switching to an Indexed Annuity Policy:
- Cost Reduction: Variable annuities often come with various fees, such as administrative fees, mortality/expense risk charges, income rider fees, and sub-account fees, which can average around three to four percent. On the other hand, indexed annuities typically have lower fees or even no fees, eliminating any negative impact on the account value.
- Capital Protection: Indexed annuities safeguard your principal by mitigating the risks associated with stock market volatility. Through the use of hedging instruments, FIAs establish a floor of zero, shielding your investment from market downturns. This feature is particularly valuable for investors who have accumulated significant gains with their variable policy and are now seeking to minimize risk.
- Increasing Income: Fixed indexed annuities offer a solution to address inflation, higher taxes, and medical expenses. These annuities provide income increases whenever the contract earns interest. In contrast, variable annuities only provide a level income that may diminish over time as the cost of goods increases during retirement.
- Higher Cumulative Income at Life Expectancy: Indexed annuities prioritize the extraction of income from the asset by utilizing income riders, allowing the policyholder to retain the underlying asset. While the initial income may be lower due to a reduced withdrawal rate, indexed annuities can potentially provide more lifetime income at life expectancy due to the income step-up each year when the index returns are positive.
- Enhanced Death Benefit: By exchanging your variable annuity policy for an indexed annuity, you gain the advantage of an enhanced death benefit from day one. Indexed annuities often offer premium bonuses to the income account value, enabling beneficiaries to choose between a lump-sum payment or receiving the benefit over a five-year period.
Drawbacks of Replacing Your Variable Annuity Policy:
- Lower Income at the Beginning: Indexed annuities, with their increasing payouts, generally offer lower income during retirement. Depending on the timing of when income is needed, variable annuities may be better suited for providing level income. Factors such as current age, expected income horizon, life expectancy, and the breakeven age should be considered to assess viability.
- Limited Growth: Indexed annuities provide the opportunity to participate in market upswings, but they can have limited returns due to caps, pars, and spreads. While this trade-off ensures that your asset is secured and protected, it also means that the focus shifts from accumulation to distribution.
- New Surrender Schedule: When replacing a variable annuity policy, the new contract will be subject to a new surrender charge schedule. This means that surrendering the contract outright will incur significant charges. Although not an additional fee, this change in the surrender schedule should be taken into account.
It is important to note that the option to replace a policy does not automatically mean it should be done. Several factors come into play when determining the appropriate asset allocation model, including retirement timeline/age, risk tolerance, and identified goals. After reviewing the most recent quarterly statement, it is essential to conduct a year-by-year comparison to consider hurdle rates, crossover points, and income payouts. Assuming the flight to safety approach is deemed suitable, there are certain dealbreakers that need to be considered.
First, it is crucial to determine if the policy has been in effect for at least three years. Selling a policy within the first three years is unlikely to be justified, as most states mandate a three-year hold period for consumer protection purposes. Secondly, if the surrender charge exceeds three to four percent, it becomes challenging to overcome this hurdle rate, particularly if the goal is focused on income generation or accumulation. In such cases it is generally advisable to wait a year or two for the surrender charges to decrease. Lastly, it is necessary to evaluate if the new contract can provide a higher income base value from day one. Depending on the income horizon, carriers typically prefer to see the new contract start with a higher income base, often aided by the premium bonus offered. If this is not the case, a detailed letter of explanation may be required although success is not guaranteed.
In conclusion, the discussion of variable annuities in relation to blackjack and the stock market highlights the need for individuals to review their financial strategies and consider alternatives that provide more stability and protection. Upgrading from a variable annuity to a fixed indexed annuity, which offers wealth generation and lifetime income without the risk of capital loss, can be a wise decision, particularly during times of market volatility or economic uncertainty. By adopting a flight-to-safety approach and prioritizing the preservation of gains, individuals can secure their financial future and minimize potential losses. For advisors who have a book of variable annuities, now is the time to start the audit process with each client.