The Pros and Cons of Variable Annuities
A variable annuity is a contract executed with an insurance company wherein an investor agrees to make a lump sum payment to the company in exchange for a guaranteed future income stream. Often used for retirement planning purposes, variable annuities come with many features and functions, some complex, and others more straightforward.
The one feature that all variable annuities inherently have in common is income stream protection. Like any other insurance contract, a variable annuity is backed by the full faith and credit of the insurance company who issues it and is backstopped by the state it was issued in. Additionally, government regulations prohibit insurance companies from using risky tactics, namely leverage, to enhance their performance, which prevents any losses from being compounded during market downturns.
Variable annuities allow you to choose from a variety of withdrawal options. You can choose to have payments spread out over a fixed period, or you could elect to have payments distributed throughout your lifetime. In a way, choosing to purchase a variable annuity contract is inherently making a bet on one’s own longevity. That is because in order reap the benefits of the investment, you will first need to outlive your own initial principal used to purchase the contract.
For example, if you deposited $250,000 into a variable annuity and the contract allowed you to withdraw $25,000 annually for the rest of your life – all things remaining equal – you would need to live more than 10 years in order to realize the benefits of the annuity. It is not until you withdraw beyond your own principal – including any associated fees – that you begin to spend the insurance company’s money and reap the true rewards of opting for the variable annuity.
At first glance, variable annuities sound like a great retirement income solution for any pre-retiree who wishes to simplify their financial planning efforts. While variable annuities do have their place in the world, they are not a one-size-fits-all solution. When deciding whether to put money into a variable annuity versus another type of investment vehicle, it is advisable to first weigh the pros and cons.
The Pros
For those who are so risk averse that the idea of watching their nest egg fluctuate worries them more than most, variable annuities present a “safety first” approach. The peace of mind alone may be worth more than any opportunity cost of not investing into the capital markets directly. However, when tax advantages, principal protections, and ability to make large lump-sum contributions are added in, a strong case can be made for incorporating a variable annuity into any retirement planning strategy.
Peace of Mind: The thought of running out of money and going back to work in old age is one of the top concerns of pre-retirees when discussing retirement. Simply put, variable annuities are meant to provide pension-like benefits that keep retirees from overspending retirement savings.
Tax Deferral: Like a traditional IRA, the money deposited into a variable annuity grows tax-deferred with its earnings only taxed at distribution. And if funds are rolled over from an IRA, 401(k), or a different tax-deferred retirement account, those funds continue to grow tax-deferred inside of the variable annuity. It is important to note that a partial rollover to a variable annuity may be a good decision, depending on financial circumstances, but rolling over one’s entire retirement savings into an annuity is typically not the best solution.
Contribution Limits: While the Internal Revenue Service (IRS) limits the dollar amount that may be contributed to a workplace retirement plan and IRA each year, there are no limits on contributions to a variable annuity in a given year.
Principal Protection: Much like any other retirement savings account, annuity contracts allow their owner(s) to name a beneficiary who will receive the contract’s proceeds if its owner passes away before the balance is depleted. A key differentiator, however, is that an annuity contract may allow its beneficiary to receive the original principal used to purchase the contract, rather than its current market value if the underlying investments have fallen in value since purchase.
The Cons
Whether deserved or not, some of the biggest criticisms of variable annuities tend to be their high fees, illiquid nature, and overall complexity. Depending on an investor’s personal circumstances, the drawbacks of variable annuities may outweigh their benefits. For others, it could be a matter of understanding the facts.
High Fees: The fees embedded in variable annuity contracts include commissions, administrative costs, underlying insurance guarantees, surrender charges, mortality expenses, and investment costs. It is not necessarily the variable annuity contract itself, but rather the method by which insurance salespeople are compensated that typically generate much of the costs associated with them. Additionally, the investments sometimes come with higher fees than simply investing in the same Exchange-traded fund (ETF) or mutual fund without using an annuity to do it.
Illiquidity: Traditionally, variable annuities are extremely illiquid and oftentimes come with steep penalties for accessing funds invested in them prematurely. Most come with a surrender period lasting anywhere from 7 to 10 years. If an investor were to experience a life change that significantly altered their financial circumstances, they would need the liquidity and flexibility to adjust their financial plan along with it.
Complexity: Variable annuities have several components, features, and guarantees that make up the overall contract. The guarantees – often called riders – are incorporated in the annuity contract and often include minimum income guarantees, principal protected death benefits to beneficiaries, long-term care coverage, and inflation protection. These guarantees come at a cost and can really add up. Moreover, it can sometimes be tough to understand what these riders cover, and which life events can trigger them.
The Solution
Over the years, the insurance business has earned itself one of the worst reputations in terms of investments and personal finance primarily due to the high pressure and misleading sales tactics of some of its most prominent salespeople. Coupled with the confusion around features, benefits, and fees, many investors have chosen to avoid variable annuities altogether in an effort to avoid the less scrupulous salespeople who frequently appear in TV ads, buy time on popular radio programs, and send mailers with invitations to lavish dinner seminars.
It is only within the past few years, inspired in part by the now-vacated Department of Labor fiduciary rule, that only a handful of annuity issuers began in earnest to create commission-free variable annuity options. Commission-free variable annuities have the same key features and income guarantees as traditional variable annuities. But as their name connotes, they have had their sales commissions stripped out. Commission-free variable annuities are completely liquid and do not have a minimum required holding period.
This distinction in compensation structure has many positive implications for consumers. Most notably, commission-free annuities can save clients up to 70% when compared with the costs of commission-based annuities. And with this change, fiduciary financial advisors may now offer their clients conflict-free advice on variable annuities under their usual fee for service arrangement. The emergence of commission-free variable annuities is a step in the right direction toward enabling fiduciary financial advisors to construct an investment framework for clients that includes protected lifetime income.
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Malcolm Ethridge, CFP® is the Managing Partner of Capital Area Planning Group based in Washington, DC. He is also the Managing Partner of Capital Area Tax Consultants.
Malcolm’s areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
Disclosures:
The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.
Investments in securities and insurance products are:
NOT FDIC-INSURED | NOT BANK-GUARANTEED | MAY LOSE VALUE