Variable annuities are one financial product we rarely see clients purchase on their own. The initial purchase is almost always done at the urging of a broker who earned a commission on the sale, with promises of guaranteed returns and protection from market risk. Unfortunately, those returns and protection may end up benefiting the insurer and broker more than the investor.
What is a variable annuity?
Before I dive into some of the common “gotcha” factors that make annuities a better deal for the insurer than the purchaser, here’s a quick explanation of how a variable annuity works. The insurer and the investor enter into a contract. Per the contract, the investor pays an initial sum (“premium”) into an account, and the money is usually allocated among various pooled investments (“subaccounts”), which hopefully grow over time. If the investments grow in value more than the underlying fees, the contract value grows. That’s the simple part.
The complex part is the rules and guarantees that govern how/when the investor can access their money. These rules are different for every annuity, but the basic idea is that at some point, per the contract’s rules and limitations, the investor starts to get paid back or withdraw their money. Some annuities tack on extra rules and guarantees (“riders”) for an additional fee. For example, the contract may continue to pay the investor a monthly sum even after the contract value falls to zero. These promises may seem great at first glance, but they often aren’t as nice as they seem.
Now, let’s explain why your annuity may be a bad deal:
Reason 1: Layers upon layers of hefty fees
Here’s an example of a potential variable annuity fee structure:
- Mortality & Expense Charge: 1.35% per year
- Rider Charge: 1.25% per year
- Administrative Fee: $50 per year
- Underlying Fund/Subaccount Expenses: 1% per year
These fees can easily get into the 3-4% range, which significantly eats away at the annuity’s value over time. Just think, if the underlying investments perform in the 5-6% range over the life of the annuity, the return on investment net of fees may not be much better than that of a safe bond.
And what’s worse, if you end up with buyer’s remorse or need access to your cash within a certain window (I’ve seen up to 10 years from the date of purchase), there may be a surrender charge. These surrender charges typically start high and decline each year, for example, 7% in year one, 6% in year two, and so on. These surrender schedules typically exist to protect the commission paid to the broker who sold the annuity.
Reason 2: The guarantees aren’t as nice as they seem
You may be thinking “but my annuity pays me 5% each year.” Read on. Often annuity guarantees aren’t all they’re cracked up to be. Here are a few examples why (and again, these vary based on each contract):
- The payment may be a return of capital, not a return on investment. Contrary to many a brokers’ sales pitch, most annuity riders don’t actually guarantee a return on your investment. That is, your contract value won’t increase by a guaranteed amount each year. Instead, what typically increases by a guaranteed percentage is the contract’s benefit base, which is a paper obligation of the insurance company that cannot be liquidated. So if you can’t liquidate the benefit base, how do you benefit from it? Typically, the benefit base is accessed by taking small withdrawals or annuity payments over time through a Guaranteed Minimum Income Benefit (GMIB) or Guaranteed Lifetime Withdrawal Benefit (GLWB) rider, and the amount of each withdrawal may be limited by the contract.
- It can take a long time to get your money back. For annuity riders that let you withdraw 5% each year, for example, it can take 20 years to recover your original investment before seeing any benefit from the contract. That’s a long time to wait before reaping the benefits of an expensive contract.
- Excess withdrawals can decimate the benefit base. By taking more than your contractually allowed withdrawal, you may decimate your benefit base at the expense of future withdrawals. This problem can be exacerbated in cases where the contract value has fallen but the benefit base remains intact. This occurs because, as is the case for many annuity contracts, any excess withdrawal above the guaranteed percentage will reduce the benefit base pro-rata based on the contract value. That means if the contract value is $50,000 for a $100,000 benefit base with a 5% guaranteed withdrawal, a $15,000 withdrawal ($10,000 above the guaranteed $5,000 payment) would decrease future guaranteed withdrawals by 20% (10,000 / 50,000 = 20%).
- If you don’t use it, you may lose it. There isn’t much sense in paying a 1-2% rider fee each year for a benefit that you may not use. For example, for contracts with a Guaranteed Lifetime Withdrawal Benefit, often investors will pay for the GLWB rider to provide a sense of security, but never take withdrawals. What’s the sense in paying for a guarantee if you won’t benefit from it?
- Investment options may be restricted. One option that an investment-savvy annuity purchaser may consider is to invest their contract’s underlying subaccounts aggressively, knowing that even if their contract value falls and they don’t see the growth they hope for, their benefit base may still go up. Unfortunately, many contracts restrict how aggressively you can invest the subaccounts, limiting the potential benefits of this more aggressive strategy.
- Fees may be charged on the benefit base, not the contract value. Oftentimes an annuity’s fees are calculated based on the value of the benefit base, not the contract value. Unfortunately, because these fees are withdrawn from the contract value itself, the effective cost may be even more exorbitant. For example, for a contract with a value of $50,000 and a benefit base of $100,000, a rider fee costing 2% of the benefit base per year is $2,000 or 4% of the contract value.
Reason 3: Tax treatment of gains
One of the main selling points for variable annuities is tax deferral. Why pay taxes on dividends each year in a taxable investment account when you can put the money in a variable annuity and take advantage of tax-deferred growth? What this sales tactic misses is the difference in tax rates between income and capital gains.
The growth in a variable annuity contract is typically taxed as ordinary income as it’s withdrawn, while the gains and qualified dividends in an exchange-traded fund (ETF) or mutual fund are usually taxed at capital gains rates. And unfortunately, income tax rates are higher than capital gains tax rates. In 2017, the highest tax rate for ordinary income is 39.6%, while the highest tax rate for long-term capital gains is only 20%. That trade-off makes the promise of tax deferral in an annuity much less attractive, especially over shorter time periods, when compared to investing in a taxable account. (Note: this analysis does not incorporate Alternative Minimum Tax or the 3.8% Medicare tax on net investment income.)
After all of this, you’re probably wondering why anyone would buy a variable annuity in the first place. The main reason to consider any annuity is longevity insurance, but there can be more cost-effective to help prevent you from outliving your money, like a fixed annuity or simply being responsible about portfolio withdrawals and how much risk you’re taking in a portfolio. Although not all variable annuities are bad products (and not all annuity salesmen are bad people), they do tend to have high fees, complex contractual language, and “guarantees” that aren’t as nice as they seem. All of that can make for a poor investment decision.
What do you do if you own a variable annuity and have buyer’s remorse? There are a few options to get out of a bad variable annuity, which I’ll cover in my next article. Stay tuned!
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