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.