November 2004
Variable annuities are a very hot financial product today. Unfortunately, for many unsuspecting consumers, they are bound to get even hotter in the years to come. As baby boomers begin to retire and evaluate their financial position, increasingly salespeople will pitch the variable annuity as the ultimate solution. Already millions of retirees have been sold on the merits of variable annuities. After hearing the rest of the story many come to learn that variable annuities can be harmful and may, in fact, be unsuitable for them.
To give you sense of their growth as a financial product, sales of variable annuities have climbed from $20 billion in 1991 to a projected $120 billion this year alone. Obviously, part of this can be explained simply by demographics. With millions approaching retirement and after the bear market, variable annuities are an easy sale. Another explanation for their growth could be the large financial incentives given to brokers and insurance agents to sell them. Given their popularity, we think there is a growing importance to fill out the understanding of exactly what is being sold to investors today.
Understanding Variable Annuities
A variable annuity can be thought of as an investment account that comes with an insurance contract. The insurance contract is usually designed to protect you from a loss of principal. The policy owner invests cash in the annuity and then typically chooses from a mix of investment options. These investment options are often just exact copies of normal retail mutual funds. The account value either grows or shrinks based on the performance of those mutual funds. But there are three common insurance policy twists that make the urge to buy very strong.
Variable annuities often come with a guarantee that your heirs will get back at least as much as you originally invested. Even if your investment choices don't produce a positive return, with this guarantee you will get back what you put in. Additionally, many variable annuities come with a feature - for an annual fee of course - that guarantees you a certain return on your money. The catch is, in order to get this guaranteed return, you have to hold the account long enough and be willing to get your money back over a long, long time. And finally, variable annuities grow without owing any taxes. That is, until you take the money out. All in all, the basic pitch is that you can't lose money, you're guaranteed a certain return on your money and you'll reduce your taxes. What some sellers fail highlight is that you will need to die, you'll have to lock your money up for many, many years and you'll eventually pay higher taxes on your gains at a later date. Without a full understanding, variable annuities can sound like a dream product. But before you pull out your checkbook to buy a variable annuity, we want to expand on some of the rarely mentioned downsides.
Excessive Costs
First, with every guarantee there is a cost - and with variable annuities it can be a very high cost. To begin with, in order to guarantee your heirs will inherit at least as much you originally put in, the insurance company typically takes out about 1.2% of your account's value each year to pay for that guarantee. So it certainly isn't a free lunch. Add to this the annual cost of the mutual fund choices you made at the start. These mutual funds cost about 1% per year and are silently taken out of your account every day. Lastly, depending on the added features that you are attracted to, such as a guaranteed minimum return on your money or perhaps the option to withdraw 20% of your money without paying a penalty, you can expect to add about 0.3% to 0.4% for each add-on. In total, it can all easily run between 2.5% and 3.0% per year for the typical variable annuity contract. To give you a little perspective, this is about triple the amount you should have to pay to have a professional responsibly manage and protect your wealth.
Decreased Financial Flexibility
Once you buy into a variable annuity, it is important to note that your money is locked up for a considerable period of time. If you later decide to bail on the policy, you could be facing a hefty and unwelcome surrender charge. The average variable annuity comes with a surrender charge period of about 7 years with the fee starting at 6% to 8% in the first year. Over the first 7 years the surrender charge wears off and then disappears entirely. Why does a surrender charge need to exist to begin with? Because the insurance company needs time to make money on your money - via its fees - to recoup the large commissions it has to pay the stockbrokers and insurance agents who sell their products. Unfortunately for most, the lost financial flexibility is rarely felt until the money is needed. If you find that you are in this situation, please don't surrender your annuity without first consulting an unbiased expert.
Taxes Disadvantages Galore
Ironically, variable annuities are often sold on the merits of their tax benefits. Over the life of the annuity, it is true that the growth in the account value is not subject to taxes. No capital gains tax and no ordinary income tax. That is, until you take the money out! At that point, whether you opt to have the money paid out over your remaining lifetime or in one lump sum, the gains in the account will be taxed at your ordinary income tax rate rather than the lower capital gains tax rate. With the recent reduction of the long term capital gains tax rate to 15%, the tax difference is often significant enough to make the tax advantages of variable annuities seem less than stellar. Studies have shown that due to the high annual fees and the onerous tax treatment when you begin to withdraw your money, it often takes 10 to 15 years for a variable annuity to outpace an ordinary investment account. Further, from an estate planning standpoint, many are unaware that their heirs won't escape the taxes on the investment buildup either. Upon death, they will also be on the hook for paying ordinary income taxes on the gains in the policy. This is in direct contrast to the benefit heirs get when they inherit an ordinary investment account. With an ordinary investment account they get to "step up" their inherited cost basis to the current market value. This allows them to avoid having to pay any capital gains taxes at all. Upon analysis, the tax benefits of variable annuities are simply not all they're cracked up to be.
Another Way
In many cases, the main motivation to buying a variable annuity is fear. Fear of losing money. Fear of running out of money in your later years. Sometimes it's a fear of saying "no" to an aggressive salesperson. The guarantees offered by variable annuity sellers are often designed to effectively play on these fears and to enhance their ability to earn a very healthy commission. Let me preface the coming statement by saying that not all variable annuity sellers push their product inappropriately. Nonetheless, putting on a so-called educational seminar with a free dinner for fifty people is a very small price to pay to get a few people to buy. We cannot say this strongly enough. We suggest that you never accept a "free dinner with a seminar" invitation - unless you are very confident that you can avoid getting sold and just want someone else paying for your dinner! But please don't forget, successful sales people are very good at selling. They do it for a living.
We continue to believe that straight forward, proper and careful investment management can produce the desired result of principal protection and income predictability. These tools can provide much greater flexibility than locking yourself into variable annuity contracts and can save you substantial amounts of money. It sounds old fashioned, but the traditional tools of reasonable diversification, prudent asset allocation and experienced management can ease your fears and allow you to avoid what many variable annuity owners eventually come to feel, buyer's regret.
"Make everything as simple as possible, but not simpler." - Albert Einstein
"A little inaccuracy sometimes saves a ton of explanation." - H. H. Munro
Jason P. Tank, CFA
jason@frontstreet.com