Variable Annuities Explained
Variable Annuities are gaining popularity in these uncertain economic times as a method of safe investing. Many people are jumping into them,however , without fully understanding what they are and how they differ from fixed annuities, much less other investment vehicles. No single investing strategy works for everyone, but variable annuities are appropriate for only a few types of investors with very specific circumstances. Variable Annuities are attractive to many because they allow for future growth while providing some guarantees against future loss. As we shall see, however, those guarantees often aren’t worth much. Many critics of variable annuities claim that they are unreasonably expensive and have low returns relative to competing investments.
Variable Annuities Explained
An annuity is much like a pension. It is a retirement plan that provides a steady and regular payment system after the accumulation phase has been completed. The exact terms of the payments and their schedule are negotiable and there are seemingly endless ways to modify the base contract using insurance riders. This means an investor must have a very good idea of what he wants from the annuity before shopping around for the best deal.
The “variable” aspect of the variable annuity deals with the sub-accounts in which the principal is invested for growth. These sub-accounts are portfolios of stocks and bonds. The rate of return on the annuity is dependent on the performance of the sub-account portfolios. The choice of which investment options available in these sub-accounts is generally left up to the customer, but the insurance company will generally limit the choices available.
Annuities are tax-deferred, meaning interest gained on an annuity will not be taxed until it is withdrawn from the account as regular income. However, because variable annuities are considered to be retirement accounts, many of the IRA distribution rules apply, including some of the early withdrawal penalty exemptions.
Variable Annuity Guarantees
The guarantees of a variable annuity are as variable as the returns of the possible investment options. Each insurance company will offer different sets of guarantees. Some companies allow the investor to pick and choose features and others offer a set package. Guarantees and features can be added later by the investment firm in order to keep up with competition. Some of the more popular features are listed below:
- Death Benefits – Should you die before the annuity is paid back in full, the balance of the account or the principal (whichever is greater) will be paid to a named beneficiary.
- Stepped-up Death Benefits – The death benefits can be adjusted upward every few years to reflect market gains.
- Guaranteed Minimum Income Benefits – An investor can choose a fixed payout time, such as 10 years, or the investor can choose a lifetime payment. The lifetime payment is a gamble that you will live beyond your expected years. If you happen to live an extraordinarily long life, the investment firm must continue payments even if your balance has been exhausted. The GMIB also provides insurance against losses from a bad market. This insurance can be on the payments themselves or on the accumulation before payout. The guarantee is usually in the form of a percentage and is almost always lower than what you could have gotten in all but the worst of market conditions (which I guess is the point).
Variable Annuity Criticisms
The biggest criticism against the variable annuity is cost. Early withdrawal fees, should they need to be necessary, can easily wipe out investment gains. Mortality and Expense (M&E) charges are also placed on all annuities. These fees range from 2 – 2.5 percent, compared to 1 – 1.5 percent with the average actively-managed mutual fund and 0.2% charged by the cheapest index funds. Also, taxation of annuity withdrawal is done at the income tax level and is not otherwise capped like capital gains are.
Annuities, while highly attractive on the surface, probably aren’t right for most investors. That said, variable annuities definitely have their place if used properly.
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Hi Kyle,
Can you spell out the scenario where the VA benefits the client? I’ve studied the prospectus for a number of them and am unable to do so.
We talk all the time about rates going up, not down, so presumably, someone for whom a $16,500 401(k) deposit isn’t enough and looking for more tax sheltering, has a high saving rate. That individual is likely to have a tax issue at the other end, at retirement, and shifting assets to convert potential long term gains to ordinary income doesn’t make much sense.
It doesn’t take many years of 2% annual fees to wipe out any perceived advantage of whatever product being discussed. I think that most people don’t understand the most basic concepts we discuss every day, risk, return, standard deviation, expense ratios, etc. Once you mix in the added fees for mortality, guarantees, etc, a VA is a product beyond the comprehension of most people.
Are you able to point to the prospectus of one that you’d be willing to discuss?
Hi Joe,
I saw your comment. I am a financial advisor in IN. You ask a great question – How does the VA benefit the client?
The biggest benefit I see for a client , after the 2008 meltdown is SAFETY. For some clients, it can be easier to sleep knowing that some of the market risk is passed on to an insurer. Of course, the insurer also needs to be strong. Guarantees are only as good as the company who makes them.
There was a great article from the Wall St. Journal last year which I refer clients to by Leslie Scism. http://www.marketwatch.com/story/long-derided-investment-looks-wise
If a client knows that they can grow over time, but there is also a safety net in place in case of disaster, it may be worth the extra cost to insure their savings.
My upcoming book, “Help! My 401(k) Has Fallen – And Must Get Up!” was written for average investors to help them get more out of their long term savings.
Dean – you don’t address how:
(a) decades of 2%/yr fees don’t overwhelm any other advantage.
(b) how high income individuals benefit by letting all their gains turn from cap gains to ordinary income.
(c) what the actual numbers are. The article cites an S&P loss vs VA small gain. Well, gold was up, as were bonds. The article was not talking apples to apples.
Why is it that I *never* see a VA salesman post a link to a prospectus for further analysis and discussion?
Joe, I think I’ll write a post on this in the next week or so.
I purchased a combination variable and fixed annuity from ING in October 2008 with a guaranteed annual increase of 7%, or the quarterly percentage increase, whichever is greater. The first quarter I owned it the value increased by 15% and it’s just kept going. With today’s interest rates being in the gutter, I’m happy with a 7% minimum. And really happy that in 18 months I’m up 20%. Plus the full balance will be transferred to my beneficiaries upon my death.
Carole – if there’s no killer in the fine print, what you have looks great. Really. With yields low as they are now, even in 2008, a 7% guaranteed return is nothing to argue against, and with some potential upside, all the better.
(I’d see like easy access to prospectuses….)