Analyzing a Variable Annuity
Variable annuities get a lot of bad press. Especially in the do-it-yourself financial independence world. The party line, which I’ve generally accepted, is that variable annuities are complex, costly products sold only to unsophisticated consumers.
Highly-respected financial writer Scott Burns wrote in Variable Annuities: A Product That Doesn’t Add Up that “The problem with variable annuities is that their most important benefit, tax deferral, costs more than any taxes deferred.”
Based on my reading, I would never buy a variable annuity. They are indeed complicated and expensive — two hugely negative factors in my view. However I was recently challenged to back up my prejudice with real-world experience, when a close relative asked me to review their variable annuity.
The project got off to daunting start when I discovered that the prospectus for the annuity was 164 pages long, and that didn’t even cover the underlying investments! Long story short, after many hours of research and phone calls, I’ve concluded that this annuity did OK, mostly because it was wrapped around an aggressive growth fund for more than a decade during a bull market.
Surprisingly, my opinion of variable annuities has softened somewhat, though not changed dramatically.
In what follows I’ll offer a brief overview of variable annuity pros and cons and my thought processes for evaluating them. Please understand that this is not a complete review or guide to variable annuities. That could be a book-length project!
These products are frightfully complex, and I don’t claim to be an expert. But I hope this article can serve as an introduction to the key issues, and a pointer to further resources for those who need to understand more on the topic….
Most variable annuities come standard with a few features, and are usually stuffed to the brim with more optional ones: Many of these seem appealing on first glance.
All variable annuities share the property of tax-deferred growth. Your underlying investments can grow over the years and you will owe no tax until you withdraw from the account.
Additionally, unlike IRAs, there are no maximum contribution limits. This can make variable annuities appealing to wealthy investors, in certain circumstances.
Annuities, like life insurance and retirement accounts, enjoy some protection from creditors in most states. Thus they could be a safe haven for accumulating assets if you are worried about lawsuits.
Most variable annuities feature a guaranteed death benefit at least matching your contributions. So, when you die, your heirs will receive at least the amount of your initial outlay. However, experienced investors are unlikely to be impressed by this benefit: Getting your money back after many years, is virtually a certainty in any other conservative investing strategy you care to choose. And a death benefit is a poor retirement planning tool for you, since only your heirs benefit.
For an extra fee, many variable annuities will guarantee to “step up” the death or other benefits over time using various formulas, such as a guaranteed rate of return of 5 or 6%. Though it’s hard to see much value in a simple death benefit equal to the initial payment, if there is a stepped up or guaranteed return feature, you cannot immediately discount that. You have to evaluate it against the cost of that insurance.
The original purpose for annuities was to provide guaranteed lifetime income. And there are a number of ways in which variable annuities can meet that need, though I get the impression that insurance companies, which would prefer to hold your money for life, often downplay it:
It’s also good to know that you don’t necessarily have to annuitize in some fashion to get some income out of annuity. You can generally make ad hoc withdrawals at any time, subject to any surrender charges and taxes.
“Living benefits” can, for a fee, ensure annuity payments while you are alive by guaranteeing the value of the annuity, the rate of return, or the withdrawal benefit.
But, when evaluating annuity income, it’s important to understand, as Kiplinger observes, that “income rider values aren’t real money and, therefore, they can’t be cashed in. Thus, if your income rider value is growing at 6% or 7%, that does not mean you are making 6% or 7%. Rather, these values and growth rates merely function as formulas to provide income”.
And, all of these features come with costs, which we’ll explore shortly….
Variable annuities come with a number of negatives too, in addition to their costs:
For starters, contributions to a variable annuity are not deductible. For this reason, most people in most circumstances will want to maximize contributions to other retirement plans before they consider a variable annuity.
And variable annuities serve almost no purpose inside retirement accounts, where their expensive tax advantages go to waste. This was the story when Chris investigated the variable annuity he was advised to buy early in his career.
Another drawback to variable annuities, significant in my view, is that their earnings are eventually taxed at higher ordinary income tax rates instead of favorable long-term capital gains rates. Coupled with high expenses, this significantly raises the performance bar that annuities must meet to make sense over simple taxable stock portfolios.
CPA Mike Piper’s article contains an excellent overview of the tax implications of owning a variable annuity: “Relative to investing in a taxable account, investing in a nonqualified variable annuity has one tax advantage (tax deferral) and a list of tax disadvantages (distributions of earnings are taxed at ordinary income tax rates when otherwise they might be taxed at lower rates, there’s no step-up in cost basis when you die, and there’s the possibility of a 10% penalty on early distributions).”
Finally, most variable annuities come with a lengthy “surrender period” during the first decade or so of ownership, during which you’ll pay a punishing fee to access much or any of your money.
The general criticism of variable annuities from the do-it-yourself quarter revolves around expenses. And a quick look at the statistics shows why the criticism is justified. (For comparison when reading these numbers, remember that the overall expense ratio on my conservative portfolio of low-cost mutual funds last year was a mere 0.12%.)
All variable annuities have a base Mortality & Expense & Administrative charge. AnnuityFYI reports that the industry average for these fees is about 1.4%. Kiplinger reports a similar statistic from Morningstar.
But that’s just the beginning.
Every extra feature rider you add to a variable annuity will carry its own additional expense ratio. AnnuityFYI reports an industry average of 0.40% for a death benefit that guarantees the greater of 5% compounded or the highest contract anniversary until the 80th birthday, and an industry average of 1.10% for a living benefit that guarantees a 5% return.
Surrender charges are far worse than that. If you decide to take money out of a variable annuity in the early years of your contract, you will likely pay a penalty starting at around 7%, before it declines to zero after perhaps seven years of ownership.
And we still aren’t done. Those are just the fees for the annuity itself. But all variable annuities contain “subaccounts” which are the underlying investments in stocks and bonds. Typically those investments are held in mutual funds, sometimes commonly available funds, but often-times proprietary funds managed by the insurance companies themselves. And those funds carry their own separate management fees, which can easily range up to 1%.
Add it all up and the typical variable annuity sold to an unsuspecting buyer will carry fees in the 2-3% range. It sounds small, but any experienced investor knows that takes a horrific toll on your money over the long haul.
The expenses on most variable annuities constitute a shocking proportion of your potential safe withdrawal rate in retirement. Yes, you could easily be giving half or your potential retirement income to an advisor or insurance company!
In decades of reading/researching personal finance, the only tools I’ve ever seen for comparing or analyzing variable annuities have been grossly simplified. I doubt that there is any reliable way to reduce the benefits of a variable annuity to a single number for comparison. In fact, I was recently told by an experienced advisor that every single annuity contract is essentially “unique” — so many are the individual variables customized to each purchaser.
In his informative book Variable Annuity Pros & Cons Todd Tresidder writes that “for the tax deferral benefit to exceed the increased costs when compared to competing, lower-cost alternatives such as mutual funds or exchange traded funds…conventional wisdom gives 15 years as the approximate breakeven point.” In other words, don’t even think about profiting from a variable annuity without holding it well more than a decade.
For my own purposes, I conducted a simple thought experiment:
Suppose I invest $100K in a conventional all-stock portfolio with negligible expenses appreciating at 5% for 10 years and then liquidate it, paying mostly capital gains taxes at a 15% rate. Bottom line: I wind up with about $138K, in the end.
Suppose instead I invest the $100K in a variable annuity with 2% expenses also appreciating at 5% for 10 years and then liquidate it, paying ordinary income taxes at a 22% rate. In this case I wind up with only about $105K, underperforming by $33K or more than 30%.
This is a simple example and ignores a host of factors, but it shows the issues at play. Variable annuities face significant headwinds in expenses and taxes over conventional investments.
For a far more sophisticated analysis customized to your situation, I recommend the Pralana Gold Retirement Calculator from our affiliate, Pralana Consulting. Pralana Gold models annuities generically and, in addition to variable annuities, can handle fixed, fixed-indexed, immediate, and deferred annuities. You can control the amount, date, account, pay-out start/end date, annual amount/COLA, duration of taxable payments, taxation percentage, survivor %, and certain & continuous period. And given Pralana Gold’s detailed federal and state tax calculations, you’ll get more accurate modeling of the tax implications of holding your annuity.
What if you own a variable annuity that you now realize was a poor investment? First, understand that these are contracts with obligations. You can’t simply buy and sell them like stocks or bonds. As described above, most variable annuities come with substantial surrender charges that you will pay for liquidating them in the early years of ownership.
However, if you discover a different annuity or type of annuity with more favorable features or costs, the government has given you a partial path to freedom — the Section 1035 Exchange. With this mechanism, you can at least defer the potential tax implications of selling an annuity, though you can’t escape a surrender charge if it’s written into your contract. There is no way around a surrender charge once you’ve passed the short initial refund period.
But understand that, even with this type of exchange, you must follow the procedures precisely to avoid creating a taxable event. Also, some of your riders may not transfer, so beware of losing guarantees based on stated balances higher than your account value. The complete case for an exchange will have many moving parts and may justify hiring a fee-based financial planner to crunch the numbers before you pull the trigger.
If you’re saddled with an expensive or inappropriate annuity and want to use a Section 1035 exchange, what are your destination options?
Sadly, investor-friendly Vanguard is leaving the business.
However, there are at least a few remaining options. Note that some of these may only be available through an advisor. While others, that manage to lower their fees by not paying a commission, you’ll have to pursue on your own.
Here are some potentially lower-cost variable annuity options that I found in a half-hour of searching the web. It’s not an exhaustive list, but will get you started if you are in that boat:
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[The founder of CanIRetireYet.com, Darrow Kirkpatrick relied on a modest lifestyle, high savings rate, and simple passive index investing to retire at age 50 from a career as a civil and software engineer. He has been quoted or published in The Wall Street Journal, MarketWatch, Kiplinger, The Huffington Post, Consumer Reports, and Money Magazine among others. His books include Retiring Sooner: How to Accelerate Your Financial Independence and Can I Retire Yet? How to Make the Biggest Financial Decision of the Rest of Your Life.]
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An interesting article, I’m sitting at home today digging deep into my finical strategy (I’m currently part time in my glide slop to retirement. Refining financial path forward)
A variable deferred annuity is a part of my solution package and one I find very reasonable. To set the stage I’m sitting pretty sweet for retirement. I maximize 401K up to company matching, IRA’s, HSAs. In my out years my RMDS will be greater than what I need. So, having an alternate tax-sheltered vehicle is very beneficial to stuff money into on the out years.
Some push back on some point you made. Initial 7-year surrender charges, this doesn’t matter to me, I have other buckets of money I can dip into if needed. I simply seeded the Annuity with a low-level amount to start the 7 year countdown. Once I reach that I will really start exercising. Athough as a FILO is a bit of a drag.
Comparison to a low fee non-sheltered account. This just does not work for me. All my portfolios are managed (historically a 1% fee) My schedule is hectic and my attempts at self-managing has not been the best. I have used two firms, and both have consistently beat the SP500 (Net. less fees). My annuity provides me this benefit.
So, I’m glad to have this investment vehicle as part of my retirement toolset. For those who need buckets in out years to handle excess funds without the need to actively manage it seems reasonable.
When are variable annuities a good options? That would be never. From an investment standpoint you can put your own annuity together by using a good index fund and a ladder of CDs. You will have paid no fees, you won’t have to worry about surrender charges, and you won’t be paying a commission for the privilege of being fleeced by (most likely) a very large and very wealthy insurance company. Stay away from annuities completely.
Another thing I forgot to mention is the financial health of the company issuing the annuity, and where they might be decades down the road. For those who say XYZ insurance company will never go out of business, well, a few decades ago no one thought Sears would be unseated as the premier retailer in America either. Have your money where you can get you hands on it more easily if you catch wind that a financial concern might be in trouble.
I looked at some simpler annuities and saw this footnote on the interest rates tables near the word Guarantee. The insurance companies have protected themselves by somewhat redefining the word guarantee.
Footnote:Guarantees are subject to the claims-paying ability of the issuing insurance companies. … When selecting a guarantee period you should consider your liquidity needs for the period’s duration.
My parents came to me several years ago to review their finances. My dad had been talked into a variable annuity within his IRA. The terms were so confusing, and I was not familiar with these products at all. After searching online we ended up hiring a financial advisory company that promotes themselves as specializing in reviewing variable annuities for a flat fee of $300. It was the best decision we made. We sent the information then had a phone conference call to discuss the contract details and get the advice of the financial advisor They were extremely knowledgeable and helpful in reviewing the options. Even though I manage all our own finances, and now my parents, these complex products can be tricky and a different solution might be best for different people based on their situation. I am very glad we sought an outside opinion to help us. I have no relationship with the company but if anyone is interested it was http://www.annuityreview.com. I’m sure lots of financial advisors could do this for a flat fee. In the end we kept it until my dad passed and transferred the death benefit amount to my mom in her IRA, closed the annuity and reinvested the cash in mutual funds and bonds.
Thanks for sharing DL. Unfortunately as Darrow wrote here and I have written in the past these products are unfortunately far more common than they should be because they are pushed aggressively by advisors who are heavily incentivized to sell them. I fear we’ll see a new upswing in these products and equity indexed annuities. The allure of “market upside without risk of losing your principle” as the sales pitch for these products often goes will look pretty good to those that don’t understand all of the costs and tax implications.
Moshe Milevsky had an interesting take about 12 years ago. He suggested that VAs with guaranteed living benefits are “pendulums”. If markets go bad in the long run they effectively “pensionice” themselves, ie, become just regular annuities as the value rests in the living benefit. If markets are strong, you get to participate in upside, but not as much as with mutual funds given the expenses.. The catch is that they are more costly than SPIAs and low-cost mutual funds in isolation. However neither fixed annuities/SPIAs nor mutual funds provide the “optionality” / pendulum of the VA. He suggested as a rough guideline, 1/3 to Plain vanilla annuities, mutual funds, and VAs. I too have long been suspicious of VAs but his view has caused me to “think about thinking about” VAs.
That’s an interesting idea in theory. The problem is that most of these products are just laden with fees and complexity. I helped my parents with a situation similar to what Darrow describes in this article. At the time Vanguard and another company whose name slips my mind offered “rescue annuities” that were specifically designed for transferring the assets in these “bad” variable annuities that people had been sold, realized they didn’t want, and were trapped in. One of these simple, plain contracts may have fit the bill for what you’re thinking about, but as Darrow noted Vanguard is getting out of this business. The other company sold as well, I believe to Nationwide. There may be similar low cost, simple VA products on the market at this time, but I’m not an expert to tell you where to look for them. Buyer beware.
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