The chatter surrounding variable annuities is louder than ever. Investors want security regarding their money in the face of increasing amounts of uncertainty about the future. Variable annuities may feed this desire with two features not generally offered together: the opportunity for growth combined with a variety of guarantees protecting both the payment to a beneficiary if the account owner dies, and the income derived from the principal amount invested.
What differentiates an annuity from say, a mutual fund investment, is that an insurance company can actually offer “guarantees.” The investment sales community, especially in light of a recent increase in disclosure requirements, must be careful about promising things to clients which they can’t provide. Having a guarantee to cover one’s principal investment, and possibly the income derived from it, is extremely appealing. In a sense, it can act as a substitute for the pension which some may hope for but never see. If you don’t have a pension, the annuity will let you turn your own lump sum investment into a customizable stream of income with a reasonable sense of security.
As with most concepts that sound too good to be true, annuities have their flaws. They are often criticized for being expensive, not always justifying their costs, and being too heavily marketed. I don’t take a hard stance in favor or against the variable annuity as an investment product. I think for some people it’s a great option, and for others (generally those with a solid background in investing) it’s probably not the best choice. I prefer to put all the facts on the table and let you form your own opinion about the variable annuity. If you’d like me to assess your situation to determine if an annuity may be right for you, please call or e-mail me.
What are the Features of a Variable Annuity?
An annuity is a stream of income. An investor can make either lump sum, or periodic purchase payments during the “accumulation phase” of an annuity. At some point, the total value of the annuity (purchases plus investment gains) can be exchanged for a schedule of payments with a variety of different guarantees. The investor can usually customize to some degree the terms of the contract.
What makes an annuity “variable” is the fluctuating performance of the sub-accounts in which they invest. Typically, annuity sub-accounts are invested in portfolios which own stocks and bonds. The total contract value will vary depending on the performance of those underlying sub-accounts. Obviously some annuities will offer better investment options than others. This is something to consider when determining if an annuity is right for you. I’ve often found that multi-manager platforms—investment options that include popular sub-accounts from a variety of investment companies —are an appealing feature.
Because annuities include an insurance component, current law allows them to grow on a tax-deferred basis. This tax-deferral allows appreciation and interest to grow tax-free until withdrawn from the contract, at which point it becomes taxable income. This is similar to other retirement plans such as the 401(k) which offer tax-deferral as well. Because annuities are long-term investment vehicles, the account owner may have to pay a 10% IRS penalty if withdrawing money prior to age 59 1/2.
The insurance aspect includes any single or combination of guarantees available from the service provider. There are often additional “riders” that can be purchased to spice up the contract as well. Many annuity providers continuously update the insurance features in an effort to give themselves an advantage over rival service providers. Here is a list of some of the more popular features offered on today’s contracts:
Death Benefit — This is a standard feature of most variable annuity contracts. The insurance company will make a payment to your spouse or other named beneficiary when you die. The beneficiary will generally receive the greater of either your account balance at the time of death or whatever your initial investment was, less any withdrawals taken. For example, if you invest $100,000 in 2002 which grows to $150,000 before you die, your beneficiary would get $150,000. On the other hand, if the markets had a sour decade and the contract was worth only $75,000 at the time of death, the beneficiary would still get the initial $100,000, assuming they hadn’t taken any withdrawals.
Some service providers offer a “stepped-up” death benefit. This feature, often referred to as a “ratchet,” will allow the contract to be upwardly adjusted every few years to lock in market gains. If the new market value is higher, your death benefit and possibly the income stream derived from it will benefit from the increase. This further entices investors by allowing the guarantee of a higher beneficiary payout, even if the market turns sour the year after the ratchet. Naturally, this sort of benefit will cost you in the form of higher expenses. Certain limits may apply with these sorts of benefits so you’ll want to read the contract carefully.
Guaranteed Minimum Income Benefits (GMIB) — If you decide to “annuitize” your purchase payments into a stream of income, you’ll have to choose a period of time over which to receive your payout. It can be a fixed number of years, such as ten, or it can be for life. The GMIB guarantees that the annuitant will receive a certain minimum amount of income while alive. The insurance company runs the risk that the account owner could live to a ripe old age, resulting in a possible loss of money on that contract. However, insurance companies are pretty darn smart. They understand that the majority of account owners will die somewhere within the standard mortality tables.
There are a few different flavors which this income guarantee comes in. Sometimes the guarantee is on the accumulation amount. Other times it is on the withdrawal amount. However you phrase it, the objectives are fairly similar. The contract will provide some form of surety regarding the possibility that your account doesn’t grow fast enough to support your payments. The minimum payment is usually either a percentage of the account value or a percentage of the stepped-up account value, regardless of how the underlying investments have performed.
The guarantee on withdrawals (GMWB) has been particularly popular because it doesn’t require the account owner to annuitize their funds, giving up a degree of control. The account owner can withdraw a certain percentage of their account each year, usually until the entire value has been taken out.*
The above benefits often work well with investors who are looking for growth combined with income. They can keep a growth-oriented asset allocation and remain confident about a certain minimum guaranteed level of income. Keep in mind that any of these additional guarantees regarding income, withdrawals, or accumulation will cost money. Investors should analyze these costs carefully to determine whether or not they are worth it.
Criticisms of the Variable Annuity
As I’ve mentioned, there are criticisms over the variable annuity. Costs, surrender charges, and tax treatment are among the complaints which are frequently thrown around. There are also mounting concerns about the use of annuities in already tax-qualified plans such as the 401k and 403b. Let’s get into some of these complaints to see whether or not they are legitimate.
Costs — The costs of an annuity depend in part on which features and riders the annuity owner has selected. That being said, all variable annuities have M&E (mortality and expense) charges, which cover the insurance aspect of the contract. When combined with the expenses of the underlying investments, annuity expenses typically run 2-2.5%, while domestic mutual funds tend to hover around the 1-1.5% level.**
My feeling is that critics are mostly concerned about what, if any value is really added by the features of an annuity. Are the insurance companies protecting consumers from real risks? Or do they simply use scare tactics to promote an investment product which lacks in value? For example, the death benefit is the primary feature of most annuity contracts, yet, once every few months I cross an article which accuses the death benefit of being superfluous. The argument is that the actual number of situations in which a long-term contract invested in stocks and bonds would decrease in value enough that the beneficiary would be better off taking the initial principal investment over the current contract value, is extremely low. If an investor considers the past performance of the markets, this benefit only affects those who purchase an annuity contract and die soon afterwards. However, insurance companies generally put an age-cap on who can buy their contracts, protecting them from extremely old people receiving too many guarantees.
If you really crunch the numbers, it’ll be clear that insurance companies are not in the business of losing money to probability. That being said, they are in the business of providing certainty of income, or “peace-of-mind.” An annuity will usually offer you that, even if a hefty price tag is attached.
We could have similar discussion about the guaranteed minimum income benefits as well, but the point is more or less the same. GMIB could be criticized as primarily a “peace-of-mind” benefit which may not be cost-effective. This criticism would probably come more from a savvy investor or other person who studies probability the same way an actuary does.
Surrender Charges: Annuities, because they are designed to be long-term savings vehicles, often have steep withdrawal penalties. In the first several years of the contract, the owner is usually allowed to withdraw only a small percentage of the contract without penalty. Surrender charges vary but are usually a descending scale from 6 or 7% down to 0% over 5-10 years.
Taxation of Earnings: Annuity benefits took a hit in 2003 when the long-term capital gains rate was reduced from 20% to 15%. Long-term capital gains (held for one year or more) are currently taxed at a maximum of 15%. However, investment earnings on annuities are taxed at the ordinary income bracket, which could be much higher. While the other benefits might still make the annuity worth it, this adds fuel to the arguments of the critics.
Annuities in qualified plans: Annuities also receive an increased level of criticism when offered in qualified plans. The argument is that since 401k and 403b plans already have tax-deferred status, the increased costs of using the variable annuity will reduce the performance of the sub-accounts over longer periods of time. Many think it’s not worth using a variable annuity for this purpose.
In fact, the SEC’s own website highlights the fact that variable annuities offer no additional tax benefit to that of a 401k or IRA plan. They caution that you should only use the variable annuity in a 401k or IRA vehicle if it makes sense because of the annuity’s other features, such as lifetime income payments and death benefit protection.
I can sympathize with this criticism as I’ve seen it in real life. My mother participated in a 403b plan while teaching which was offered through a variable annuity platform. She had major problems transferring in and out of sub-accounts because of the surrender charges. She also found that the high costs were holding back the performance of her investments, especially during sideways markets. The problems were compounded by the fact that a low-cost mutual fund platform would have offered the same tax-deferred status at a lower cost. Upon doing some research, we were able to transfer her out and into a lower cost alternative.
The Bottom Line
This is the basic story with annuities. A true do-it-yourself investor could probably manually create a cheaper product by purchasing insurance contracts for the death benefit, and having low-cost investments centered around bonds and dividend-paying stocks for the income stream. Plus, you wouldn’t have to deal with any holding periods or surrender charges. While it may ultimately be cheaper this way, it would require a certain degree of research and knowledge about what you want to sort through the various risks and choices.
Having dealt with the annuity question in my career, I can state that peace-of-mind is often what keeps clients interested in this type of product. I’ve noticed that the media often points to the commission paid to brokers and advisors for the surge in variable annuity sales. While it may be a factor, the decrease in pension benefits and government entitlements is more likely the primary driver in annuity popularity. The comfort and convenience of packaged products is definitely a factor as well. Justifying higher costs in the face of convenience to do-it-yourself investors is near impossible. If you have a good financial planner, they should be able to explain the attributes of the variable annuity clearly to you.
This is certainly a lot of information to digest. If you have any questions or comments, please don’t hesitate to contact me.
Russell Bailyn
—
Wealth Manager
Premier Wealth Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *231
F: 212-752-7673
rbailyn@premieradvisors.net
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
* Guarantees are based on the claims-paying ability of the issuer. Surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. The investment returns and principal value of the available sub-account portfolios will fluctuate so that the value of an investor’s unit, when redeemed, may be worth more or less than their original value. Optional features may involve additional fees.
** According to the Variable Annuity Research and Data Service, 2.148 percent is the average for variable annuity expenses as of March 31, 2006. Average mutual fund expenses are 1.32 percent, based on data as of June 30, 2006, compiled by Morningstar, Inc., of the average expense ratios of domestic equity, taxable bond, municipal bond, and foreign equity mutual funds.