When most people shop for an annuity, they care about independent ratings that grade its financial strength. In fact, they care a lot. Indeed, a strong case can be made that they care too much – and to their detriment.
It goes without saying that a prospective annuity buyer wants to make a safe investment. The purchase of an annuity – unlike, say, a stock or bond or REIT – is often a lifetime investment. It is critical that annuities make good on their lifetime payment promises and perform properly overall as they may be the biggest source of income for retirees.
Prospective annuity buyers are well aware of this. Financial planning firms say that up to 75% of shoppers commonly say, at least initially, that they want the highest-rated annuities available. When told that good, safe annuities with strong ratings — but not the top rating — pay more, only about half of them agree to consider them.
The other half, however, do not. Depending upon how much they invest, which type of annuity they buy and the duration of payments, that decision costs them thousands of dollars, sometimes hundreds of thousands of dollars, of income.
The Psychology of an Annuity Buyer[>
Why do annuity buyers behave this way?
Some financial advisors say it boils down to one word – fear. People buy annuities because they are fearful of risking all their money in stocks and bonds. They want an annuity that will deliver – period – and in the case of a lifetime income rider, in particular, they won’t tolerate any possibility of risk. Hence, many make a point of buying annuities from only New York Life, MassMutual or Guardian – the three top-rated insurance companies.
In so doing, they largely ignore so-called opportunity cost – the opportunity to put the same dollars elsewhere and earn more. Theoretically, at least, limiting purchases to only the highest-rated insurance companies can also aggravate the single-biggest fear among most retirees – running out of enough money to live decently. If a retiree runs into unexpected financial problems, an additional, say, $100,000 can make the difference between weathering the storm and facing financial disaster.
“Annuity buyers need to understand how big a chasm there is between an insurance company’s rating and what it pays,” says one financial advisor. “It’s like the grand canyon. Investors looking at annuities really need to be open-minded and look at more than one or two insurance companies. Otherwise, they are short-changing themselves.”
A.M. Best is King among Insurance Company Raters
A.M. Best is the premier insurance company rating agency. Its rating process, like others, involves quantitative and qualitative reviews of a company’s balance sheet, operating performance and business profile, including comparisons to peers and industry standards and assessments of an insurer’s operating plans, philosophy and management.
Its highest ratings are A++.and A+. This means that the company has “superior” ability to meet ongoing insurance obligations. The next step down is A and A-. This means the company has “excellent” ability to meet ongoing insurance obligations. Next down is B++ and B+. This means the company has “good” ability to meet ongoing insurance obligations.
Are these differences huge? The answer probably varies from one investor to the next. What seems clear, however, is that an A or A- rating is definitely good enough, and probably so, too, is a rating of B++ or B+. If you don’t agree, also take into consideration the financial haircut you take if you insist on buying from only an A++ or A+ company.
What a Higher Insurance Company Rating Costs You
Say, for example, a 60-year single Florida man invests $250,000 in a six-year multi-year guaranteed annuity (MYGA) – essentially a plain vanilla fixed annuity. One carrier rated A- pays 3% annually. An A++-rated carrier pays 2.25% annually on the same annuity. If you buy this annuity from the first carrier, your total payments will be $298,513. If you buy instead from the second, they will be $285,706. That is a difference of nearly $13,000.
Arguably, this may not be that big a price to pay for the additional piece of mind. But the longer the duration of the investment, the bigger the difference in payouts.
Say this same 60-year-old invests $250,000 in a fixed indexed annuity (FIA) with a lifetime income rider and defers payments for five years. The man who buys this FIA from an insurance company rated A- collects a monthly payment of $1,533 — $203 more than if he bought it from the carrier rated A++. That’s a difference of $2,442 annually.
Still not all that much, right? But the differential ads up over time. If our Florida man lives to age 80, he would earn $36,690 more in total payments. If he lived to age 90, he would earn $73,000 more. In addition, in this case, the lower-rated FIA offers a more generous participation rate on the underlying index, meaning that a beneficiary would probably receive more money.
Lastly, it’s important to be aware of a worst-case scenario. In the highly unlikely event that an insurance company fails, states offer annuity owners partial restitution. Most states will make payments up to $250,000, after subtracting annuity fees.
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