Variable Annuities, Part 2
November 24, 2008
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“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 The major benefit to an annuity is the ability to defer taxes until the money is withdrawn.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Add the fact that gains in an annuity are taxed as ordinary income when withdrawn and the chances of your annuity beating your taxable account come close to zero.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.
For the last 5 years I have consulted large insurance companies around the world on designing, pricing and hedging variable annuity guarantees and would consider myself an expert in these products. Like any other sales profession there are both honest and dishonest sales people. I think that it is important that people continue to publish unbiased information so advisors and consumers can make up their mind themselves.
In the case of this article, the author clearly has a point of proving that variable annuities are not good investments – which is fine as long as they stick to the facts to make their arguement.
Most of what I read in this article seems to give reasons why annuities were not great investments 5+ years ago. Some points may still hold today. However, in recent years the landscape has changed dramatically through the introduction of living benefits.
Today, the main reason why people purchase variable annuities is for the living benefits. That is why over 75% of contracts elected living benefits in 2007.
It is clear from the lack of any real content in the living benefits section above that the author has not been keeping up to date with these features.
I acknowledge that these products are complex and difficult at times to understand. That is a fair assessment, and I would have had no problem with that sort of critique.
However, what I do have a problem with is the use of fear tactics imployed in the living benefits section. This is no better than the dishonest sales guy trying to sell an unfit investment product.
Comments such as, “If you are being told that regardless of stock market performance you can withdraw 7% of your account annually, beware.”
Beware of what? Before you make a comment like this, pick up a prospectus from a top va writer and read it. You will see that these products do indeed exist with no strings attached. This is simply a lazy and unwarranted comment.
As long as you are going to a trusted insurance company you can buy this product and feel comfident you are paying for what you get. The one described has been around since 2002 (Hartford’s Principal First rider), and when it came out, it sold way more than anyone had expected due to the value it offered investors (guaranteed return of principal with equity market upside).
However, more recently, the lifetime Guaranteed Minimum Withdrawal Benefits are now the hot sellers. These products typically guarantee the investor gets at least 5% a year of original principal for life regardless of market performance (with opportunities to increase the annual income amount further). The one restriction that you may come across is that there may be certain asset allocation restrictions. And the reason why that would be in place is so that they can keep the cost of offering the guarantee down. Otherwise it would cost the insurer more money to manage the risk and obviously that would have to be passed on to the consumer.
Here’s the real deal. VA’s offer consumers unparalleled market and lifetime income guarantees while also allowing them to participate in the market upside. This clearly offers a value to the policyholder. The real issue that each advisor needs to work through with their clients is if the value of these guarantees are worth the fees.
One final point. I do not sell these products, I just help companies design them. I know they are complex. That is why I am always happy to discuss these products with advisors and potential clients to help them fully understand the facts. If the author or any other readers would like to discuss these products, I would be delighted to help out..
Best Regards,
Ryan Hinchey
Correct me if I’m wrong, but the GMWB basically says if you give me a dollar I’ll pay you back $.07 (assuming a 7% withdrawal benefit) until I’ve paid the dollar back in full. Further, on top of the already high fees on the product, I’m going to charge and additional fee for this privilege. Who would consider that a benefit?
Of course, many agents present worst case scenarios to show why this really is a benefit to the client. But really, would insurance companies sell these if they weren’t the ones getting the benefit???
Honestly, I think the GMWB does have potential. But I would love to see a stripped down version that is cost effective to the consumer. Until then, the products are not worth the extremely high costs.
Roger,
I have studied variable annuities for years and years. They are a tool, like any other tool. And the benefits derived from their utilization needs to be compared against the benefits of other tools. So, at the risk of being shredded by the insurance industry for my views, I’ll add in my “two cents.”
Roger, like you, I soundly question the quality of the real benefit – of any type – offered by variable annuities which possess high fees and costs. Your blog does an excellent job of noting that most variable annuities possess mortality fees, administrative fees, extra fees for many of the new riders, the various costs of the funds themselves (both the annual expense ratio and the often non-disclosed and seldom discussed transaction costs), etc. NAPFA members do an extraordinarily good job of ensuring that whatever fees and costs are paid in connection with investments result in real value to the investor. As your blog points out, the math for high-cost annuity products just does not work out.
For example, take the GLMWB (guaranteed lifetime minimum withdrawal benefit) rider for life, which gives investors the ability to withdraw a fixed percentage (e.g. 5%) of the benefit base each year until death. (The older GMWB riders generally promised a withdrawal benefit for a period of years, not over one’s lifetime.) The benefit base can rise annually when the market has performed well, but will not fall. So, investors are protected against any nominal investment losses in a down market without losing the benefit of upside gain in a strong market. In exchange for this benefit, the investor pays a fee each year, and the remaining contract value at death is paid to beneficiaries. All this is true. But if the benefit base is so reduced by the compounding effect of high fees and costs over time, the investor is very rarely benefited by this feature, and often severely impacted in a negative way. THIS IS RARELY DISCUSSED by annuity salespersons. Deferred variable annuities with guaranteed withdrawal benefits for life are typically sold as an alternative to an immediate annuity with lifetime income. The former offers full liquidity and the ability to bequest assets remaining at the account holder’s death to heirs. But, it typically costs more and pays out less than the immediate annuity.
I think just about every “rider” can be evaluated, and if the high fees and costs of the annuity contract (and rider) are objectively viewed, the same conclusion will be reached … the high fees and costs incurred during the accumulation phases just don’t justify the benefits promised later. Except in those rare cases where the market suffers a substantial and prolonged decline in value – for years upon years – the “guarantees” offered by the annuities are typically just not worth the benefits provided.
In my view, nonqualified variable annuities should be evaluated, first and foremost, as an investment vehicle. When evaluated as an investment, I believe that there are many alternatives that are much more attractive and that allow the investor to retain the control, flexibility and access to their money. Additionally, the tax aspects of any investment product must be surmised and understood, prior to recommending the product.
For investing in equities (i.e., stock funds), there are many extremely tax-efficient stock funds and ETFs which are unlikely to have capital gain distributions for many years (if ever). While it appears we may be headed for larger long-term capital gains rates in future years, I still like the availability of securing LTCG treatment instead of the ordinary income treatment which results from growth inside variable annuities. (Generally, the amount an investor receives in a full surrender of his or her annuity contract at any time is tax free to the extent of any cost that the investor has not previously recovered tax free. The rest is taxable, as ordinary income, of course.) Tax deferral is not just available through annuities – it can be secured by nonrealization of capital gains, as well.
As seen recently, harvesting capital losses is also a key benefit of stock funds and stock ETFs in taxable accounts. The ability to harvest by tax lots is even better. In contrast, to harvest a loss in an annuity contract, the annuity contract must be surrendered entirely (often resulting many times in a greater loss if surrender fees are imposed, which is usually the case in early years for the high-cost, broker-sold variable annuities). However, in such situations, the loss on an annuity which is surrended is an ordinary loss, which is generally more tax beneficial to an individual investor than capital losses (although there seems to remain some dispute as to whether this loss is subject to the 2% AGI limitation). [Of course, note that capital losses from one investment can reduce the capital gains from other investments during a tax year, and capital losses can be offset against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). For individuals, losses not used this year can offset future capital gains.]
Also, qualified dividend treatment (if it remains available in future years) promises additional tax benefits – not necessarily deferral of tax, but payment of tax at rates which are often far less than the tax which would be paid in later years upon deferred gains coming out of the variable annuity.
Of course, the tax penalties upon surrender (where gains are present in the variable annuity) prior to age 59 1/2 rule out nonqualified variable annuities for younger persons in many instances (why risk the tax penalty if a liquidity event occurs; annuitization to avoid tax penalities is a poor replacement for actual liquidity). Hence, perhaps nonqualified annuities are more attractive to retirees.
But then again, for retirees, perhaps the biggest downside to variable annuities results from a loss of stepped-up basis at time of death on investment gains. I have not met a single client who would like to transfer an income tax burden to his or her individual heirs, yet that often results with nonqualified tax-deferred annuities. Even worse, imagine a Florida retiree, perhaps in a 15% marginal income tax bracket (with no state income tax), leaving a nonqualified annuity with gains in it to children who work and are in higher marginal federal income tax brackets – and who often reside in states with state income tax. I saw it happen, many a time, in my prior law practice. And I never met an heir who was happy to receive a tax liability – the heirs often cursed the annuity salesperson at that time.
Another large downside is the complexity of these variable annuity products. Have you ever met an individual investor who truly understood the guarantees offered (and their limitations), the fees and costs of these products, and their tax benefits AND drawbacks? I have yet to meet one. It’s a complex financial world out there. As I’ve written often, our fellow citizens deserve trained and competent fiduciaries as their investment advisors – not product salespeople who are ill-trained to understand the tax, fee, and cost characteristics of the products which they sell, or even if they do understand them don’t put the best interests of the client first and foremost at all times. I have a saying to prospective clients who visit our offices and who already own these expensive variable annuity products which are so often a poor investment solution for the client – the salesperson either “didn’t know” or “didn’t care” – or both.
Having said all of that, there are some no-load, low cost variable annuities (Vanguard and Fidelity among them), and some flat insurance fee annuities (such as Jefferson National, whose VA I have yet to personally evaluate, but which has been the subject of commentary in these forums), which may be attractive to investors. This may especially be true for investors holding fixed income assets in nonqualified accounts, who are near or over age 59 1/2 (so no tax penalty exists in the event of a liquidity event), whose marginal income tax rate is likely lower in future years (due to less income, or possible offsetting deductions – such as large medical expenses later in life); or who is likely to leave the annuity to those in lower income tax rates, or leave the annuity to a qualified charity.
I also acknowledge (but annuity advocates should not take this out of context) that diversification of investment holdings by tax characteristics is often wise. Would not a 50-year old client, who is perhaps 10-15 years away from retirement, and who is unlikely to have any pension income in retirement, benefit from having a combination of qualified retirement plan income, tax-free income or growth (in the form of Roth IRAs or Roth 401ks), and funds in taxable accounts? The prudent investment adviser would be able to match up the investor’s asset allocation with the tax characteristics of each account. In the unusual situation today where the investor possessed insubstantial amounts in qualified retirement accounts and traditional IRAs, tax diversification through ownership of a low-cost variable annuity, which in turn holds low-cost bond funds, might make sense.
Lastly, we must acknowledge that the risk protection features of variable annuities, while often illusory in the real world, are attractive to many individual investors. While many of us believe greatly in the low-cost, tax-efficient investment strategies which we advocate, especially for investors with long-term time horizons, the recent substantial market downturn and high market volatility have unnerved many of our clients. While we earn our pay in recent weeks by ensuring that our clients adhere to the investment plan we have laid out for them (or by other strategies, which will not be debated here), we must also acknowledge that some of our clients may not be sleeping well at night. While variable annuities may not have provided real downside protection, what about equity-index annuities (EIAs)? I have not yet encounted an EIA that I yet like – as they also possess (effectively, due to limitations on crediting, use of price-only indices, etc.) high fees and costs. But, someday, perhaps some firm will create and market a relatively low-cost, no-load EIA which might be worth recommending. Also, as was previously discussed in the NAPFA discussion forum, some investors would be well-served to consider low-cost immediate lifetime annuities, for a portion of their portfolio, especially those with annual distribution amounts adjusted by changes to the U.S. Consumer Price Index (not a reflect of a retiree’s personal rate of inflation, but still an adjustment, nevertheless).
This is a long reply, yet the complexity of variable annuities in particular, and annuities in general, has just been touched upon. So many salespeople (and articles of late) tout the benefits of the “new riders,” while little discussion seems to occur in the financial planning press of the many limitations (and, at times, harm), done by high-fee, high-cost variable annuity products. VAs, EIAs, and immediate annuities all have their place in the investment world, but it is very likely that, at least for VAs and EIAs which have high effective fees and costs, the space they occupy in the collective portfolio of American investors should be far less than what it is today.
I applaud you, Roger, for speaking out on this issue. I hope this post contributes positively to your efforts to unveil the often-hidden detrimental aspects of these highly complicated and often-expensive variable annuity products.
Ron
If you are going to quote a book such as Scott’s you may want to make sure that the assumptions are still valid. In addition many of the “ranges” used in the calculations are rather misleading,you can say that a range of 1% to 4% is fine but if the 4% is an outlier then should it be used if the range is 1% -2%? In addition the death benefit may not be “worthwhile” but the truth is that it does not depend on how long the annuity is held but the value upon death. I think that each camp, pro and con enjoys distortion and that only leads to confusion on the consumers part. Be passionate but be accurate and honest.