Don’t Put Your IRA in a Variable Annuity

I recently received an email from a couple in their 60s requesting advice regarding how to invest their IRA funds. They had been to a “financial planner” who recommended a variable annuity. Luckily they had read my posts on the subject and said in their email that they were “skeptical because of the costs and early withdrawal penalties.”

I heartily concur.

Jeffrie Voudrie’s article Don’t Put Your IRA in A Variable Annuity explains why.

Here’s a quick summary.

If you’ve talked to a broker or agent about rolling over your retirement account, there’s a good chance the advisor recommended you invest in a Variable Annuity. Don’t do it! I believe the only reason a variable annuity is recommended for an IRA is so the advisor can earn more money. Let me explain.

One of the main sales ‘hooks’ used in selling a variable annuity is that you don’t have to pay a commission. That can be very compelling when compared to a mutual fund in which you pay the all the commission up-front. Many advisors will even say that they get compensated by the insurance company, not you. Do you really believe that? Insurance companies are not charitable organizations. If they are paying the broker, they’ll recoup those costs from you—the costs are just hidden so you don’t think you’re paying a commission. The second main argument for using a variable annuity for an IRA is the death benefit (not offered with a mutual fund). “That way you’ll never have to worry about your beneficiary getting less than you invested”, the thoughtful advisor says. This feature may seem nice, but you end up paying through the nose for it.

The real reason that you are recommended a variable annuity for your IRA isn’t that it’s better for you. It’s because it’s better for the advisor. If you invest $500,000 in a commission-based mutual fund, the advisor’s gross commission will only be about $10,000. The same investment in a variable annuity would yield gross commission to the advisor of $30,000-$35,000 or more! If an advisor can earn 3 times more by getting you to invest in a variable annuity instead of a mutual fund, which do you think will be recommended? 

Don’t fall for the ‘put your IRA in a VA’ trap.

Conclusion

I am not sure which is more shameful (1) Wall Street titans who took outsized bonuses that turned out to be based on illusory profits or (2) the bad advice given to consumers every day by “financial advisors.” This self-serving advice costs consumers billions of dollars every year.

There is a better way - fee-only financial planners. To find one near you, consult this web site:

National Association of Personal Financial Advisors (NAPFA)

Variable Annuities, Part 2

“It has always been said that annuities are ‘sold,’ not bought by investors. Over 90% of all annuity sales are through brokers or life agents… Why are so many people sold annuities? The answer is simple…. high commissions and great sounding stories.” – Scott Dauenhauer.

In a previous post, I outlined some of the disadvantages of variable annuities. Today’s post goes into this a bit more deeply.

A colleague of mine, Scott Dauenhauer of Meridian Wealth Management, is a former stockbroker and someone who is quite critical of the “so-called” advantages of variable annuities that are usually touted by salespeople. The following quotes from Secrets of the Wirehouse and How to Protect Your Best Interests emphasize the high (hidden) costs and lack of real benefits.

Annuities, Hazardous to Your Wealth?
Variable annuities performance is based on an underlying “sub-account,” basically a mutual fund. The major benefit to an annuity is the ability to defer taxes until the money is withdrawn. Another highly touted benefit is that an annuity can pay an income stream for life. Let me lay out a case for why variable annuities may be hazardous to your wealth.

The expenses inside an annuity are one of the main problems. There are several expenses involved. Today most annuities do not charge you an upfront commission, the fee is charged as an annual fee (which you don’t see). This fee is deducted daily from your balance, there are five possible costs. The costs are: The policy charge, Mortality & Expense, Rider charges, underlying sub-account expenses, & transaction costs associated with those sub-accounts. Below is a range of what these cost can add up to:

Policy Charges                                   $ 30-50

Mortality & Expense                        1.00 – 2.00%
Riders                                                .25 – 1.25%
Sub-Accounts                                   .25 – 1.50%
Turnover Costs                                 .06 – 1.00%

Total Costs                                     1.56 – 5.75%  Annually

These expenses take a toll on the ability of the portfolio to match, or even beat the market. The annuity has to earn 2.5-5% before it breaks even for the year.

Add the fact that gains in an annuity are taxed as ordinary income when withdrawn and the chances of your annuity beating your taxable account come close to zero. In addition, if you die with an annuity you do not receive any favorable tax consequences. You lose what the tax code refers to as the “step-up” in basis, meaning that if you die with a taxable account the entire account gets passed on to your heirs with no income or capital gains tax, not so with an annuity.

You may ask “what about the guaranteed death benefit?”

It is basically worthless in most circumstance. Annuities are long-term investments, they are not meant for periods of less than 10 years. If you end up being one of those poor unfortunate souls that bought at the top of the stock market and still have less money than you started with 10 years ago (extremely unlikely, but it happens, though usually due to idiot broker advice) then your loss exposure is likely minimal. An amount that will be less than what you probably paid for the insurance over that period. In any event, the death benefit is not a logical reason to purchase an annuity.

Now, of course, if you have loved ones that you want to provide for a death benefit may offer you some peace of mind. Keep in mind what you pay for that peace of mind and the likelihood of it ever being collected on. If you are insurable, purchase insurance; if you are not, perhaps a variable annuity with a death benefit makes sense (though I still highly doubt it). If in the extremely rare circumstance that a death benefit makes sense in a variable annuity my choice would be to purchase a variable annuity from the Vanguard Group, as they offer a low cost account with a death benefit.

Let’s recap the problems with Variable Annuities. High expense, high marketing costs, tax penalties if under 59 ½, loss of capital gains status, loss of step-up, limited choice of investment vehicles, & worthless death benefits. So why do people continue to be sold these products? High commissions and high profitability to the companies involved. Profit is the bottom line, not your interests. Variable annuities have become such a problem that the SEC (regulator) has issued a booklet available online through its website that lists the pros and cons of annuities.

Living Benefits

Variable Annuity providers knew that the death benefit just wasn’t enough to keep the sale of variable annuities going, so they came up with a whole new generation of benefits for variable annuity products dubbed Living Benefits. The four major living benefits that are offered are as follows:

Guaranteed Minimum Withdrawal Benefit (GMWB)

Guaranteed Minimum Withdrawal Benefit For Life

Guaranteed Minimum Income Benefit

Guaranteed Minimum Accumulation Benefit

These living benefits are sold with some really great stories and too good to be true promises. I can’t even begin to get into the inner workings of each of these so called benefits because it would bore you and take up a lot of space. Suffice it to say that these living benefits are expensive (despite what your broker will tell you) and are not all they are cracked up to be. If you are being told that you will be guaranteed 7% on your money, beware and read the small print. If you are being told that regardless of stock market performance you can withdraw 7% of your account annually, beware.

The stories that are used to sell these products are wonderful, they sound like an investors dream, but reality is much different. These products are costly and in most cases fixed against the possibility of a claim being made. Always read the fine print and hire a professional who has nothing to gain to review any variable annuities recommended to you.

The “Bonus” Annuity Scam
If you are an annuity holder, chances are you have been approached by an insurance agent trying to sell you an annuity that pays you an ‘upfront’ bonus. Whatever you do, do not succumb to the sales pitch for the new “bonus” annuities. This is a new and highly aggressive tactic of the industry, to keep investors “imprisoned” in a high cost product, and generate new and even larger commissions for the sales force. Annuity holders with a few years left in their surrender charge period are approached with the following “typical” story:

“I understand that you are unhappy with your current variable annuity because of poor performance, lack of investment choices & a fading death benefit. I also understand that you have a surrender charge left. We are going to “help” by giving you an up-front ‘bonus’ of 3-6% to cover the surrender charge. It will not cost you anything to switch.”

Unfortunately, the only “bonus” is to the salesperson. The new sale starts the surrender period all over again and the salesperson gets another commission. It is a great deal for the agents, they get two commissions from you.

To pay for the bonus and the commission and any extras, the insurance company raises the expenses on your investments. Since these expenses are buried in the prospectus and hidden from you on your statements, you never know that you are being taken advantage of. When all is said and done, everybody is making money except you! I have actually been in meetings and heard brokers laugh at how they duped another person into a “bonus” annuity.

They refer to the extra commission internally as the “Yield to Broker.” It appears that the SEC is coming down hard on this practice. On June 5th, 2000, they issued an “investor alert” and placed a brochure on its website to help investors understand the benefits, costs, and risks of variable annuities, which combine features of mutual funds and insurance.

Insurance companies have been hit with rounds of lawsuits stemming from churning and suitability. It seems that the real “bonus” will be new business for trial lawyers!!!

Conclusion

When someone, specifically a salesperson who is compensated by commissions, recommends a variable annuity or a “bonus” variable annuity, you should seriously question whether the recommendation is in your best interest (or his). Take it from an ex-stock broker; that recommendation may very well be prompted by the promise of a very high commission.

Read about IRAs and Variable Annuities.

photo credit: loop_oh

Variable Annuities, Part 1

“High fees, low flexibility and ‘horrendous’ tax treatment make variable annuities less attractive than ever, except to the people who sell them.” – Liz Pulliam Weston.

Annuities may come in more flavors than Baskin Robbins ice cream, but don’t make the mistake of assuming that they are as simple as choosing between chocolate and vanilla. In truth, they are very complicated products. A variable annuity is an insurance contract that allows you to invest your premium in various mutual fund-like investments. If you are considering buying an annuity, you must do your homework before making a final decision. CNN.com’s annuity guide is a good on-line primer

SmartMoney.com summarizes as follows.

A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn’t subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as “subaccounts.” Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it’s time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

Since the person recommending the annuity will (no doubt) tell you how “great” this product is, this article will temper that by focusing on the disadvantages of a variable annuity.

Sold not Bought

In financial circles, it has often been said that annuities “are sold, not bought.” And sold they certainly have been — there is more than $1 trillion invested in variable annuities, and new sales total well over $100 billion every year.

However, the popularity of an annuity as an investment does not necessarily suggest that it is wise for you to invest your hard-earned money in it.

So are variable annuities good for investors?

Liz Pulliam Weston, who writes a column for MSN Money, gives away the answer in her article’s title The Worst Retirement Investment You Can Make.

Calling it the “worst” investment may, perhaps, be a slight exaggeration. Let’s look at her main points.

Tax treatment. Your gains in an annuity grow tax-deferred, but they are taxed as income when you withdraw the money. That contrasts with other investments such as stocks and mutual funds, which can qualify for lower capital gains treatments.

Penalties for early withdrawal. Variable annuities are designed as retirement savings vehicles. So, you pay a 10% federal-tax penalty if you withdraw money before age 59½. Insurance companies typically levy surrender charges of their own if you withdraw more than 10% of your balance in the first few years. Surrender charges usually start at 7% of your investment and decline to zero over the next six to eight years. They can range, however, up to 16% and last for as long as 15 years.

Death benefit. Variable annuities typically come with a death benefit that ensures your heirs get back at least as much as you invested if you’re unlucky enough to die while your investments are down. Your heirs will have other problems if you die owning an annuity, however. While most other investments get favorable tax treatment — a so-called “step-up in basis” that eliminates or drastically reduces the taxes heirs must pay when they sell — withdrawals from an annuity are taxed at regular income-tax rates.

Living benefits. Death benefits aren’t the only insurance feature you can get with a variable annuity. Increasingly, insurers are pushing so-called “living benefits” or “life benefits,” which guarantee that you can get back at least your original investment, usually compounded by a certain amount, when you withdraw the money in retirement. Investors stung by the bear market are greatly attracted to these guarantees, Carey said. That’s helped fuel annuities’ rise. Living benefits were available on 20 of the 25 top-selling variable-annuity contracts last year.

Costs. The insurance features of an annuity aren’t free, of course. The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost.

Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio.

If the underlying investments returned 8% a year, after 30 years:

Your variable annuity would be worth $362,177.
Your mutual funds would be worth $431,874 — a difference of nearly $70,000, or 14 years’ worth of contributions.

The gap just widens if you consider the tax implications. In both scenarios, you won’t have to pay tax on your original contributions when you withdraw the money. But the mutual fund gains would in most cases qualify for capital gains tax rates, which range from 5% to 15%, while the annuity’s payments would be taxed at income tax rates — currently 10% to 35%.

Are the life benefits worth it?

Meanwhile, the chances of your actually using the insurance benefits are slim. Relatively few people will die with their annuities worth less than what they paid. The living benefits typically come with a 10-year holding period, and there have been few 10-year periods where investors have actually lost money.

Insurers argue that the life benefits serve as “guard rails,” allowing investors to take more risk with the knowledge that their basic investment is protected. Many financial planners respond that a more appropriate response to risk is to construct a balanced, diversified portfolio with bonds and cash to cushion stock market swings.

Of course, most variable annuities aren’t bought — they’re sold. Only about 2% of variable annuities are purchased directly by consumers; the rest are sold through brokers, insurance agents and bank employees who are paid often-hefty commissions on their sales.

The math is lousy

“When you take the commissions out of the equation, the allure of a variable annuity disappears,” said Miami fee-only financial planner Frank Armstrong, a former insurance agent and author of “The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio.” “They cost a bundle,” he added. “And the tax treatment (upon withdrawal) is horrendous.”

“Nobody who’s in the fee-only (planning) business is going to recommend them,” said Armstrong. “Why do you think that is? You think we just have a blind spot that we can’t do the math?”

Some of most vociferous critics of variable annuities are those who, like Armstrong, spent some time in the brokerage firms or insurance companies that push them. Before he became a fee-only planner, Rob Pool of Portland, Ore., worked for a major brokerage firm, and the experience made him wary of the way annuities are sold.

“They’d get recommended even if it wasn’t in the client’s best interest all the time,” Pool said. “I can’t say there’s never a place for a variable annuity in a portfolio, but I haven’t found it yet.”

Conclusion

Personally, I do not recommend variable annuities for my clients, because they are not in my clients’ best interest, and there are much better alternatives. Variable annuities have very high expenses, unfavorable tax ramifications, and they lack flexibility. Before buying one you should understand the surrender charges, early withdrawal penalties and the annual fees. It bears repeating, do your homework before you consider buying an annuity.

Larry Swedroe and Jared Kizer in their new book The Only Guide to Alternative Investments You’ll Ever Need say this:

Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred. Make no mistake about it, the complexity is intentional. After all, if the investor fully understood the product, it is likely that he or she would never purchase it. That is why many of such products are truly “tourist traps” – designed to be sold, but never bought.

Education – or a good fee-only adviser who is not influenced by commission-based compensation – can be the armor that protects investors. The overwhelming evidence from academic studies on Variable Annuities is clear: In general, these investments fall into the category of products that are meant to be sold, not bought.

Read Part 2.