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

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.

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