Today I am going to talk about variable annuities. I do not sell them, in fact I don’t sell any investment products but most “financial advisors” do sell annuities. If you think today’s politics are polarized either hard left or hard right that’s nothing compared to the question of whether annuities are good or bad. On one side you have consumer advocates and some financial advisors that don’t sell annuities and on the other side are financial advisors (life insurance agents) and insurance companies.
I don’t look at them as being good or bad. I have no problem with people buying a variable annuity if they are an informed buyer and completely understand the product and all of the conditions in the annuity contract. But in my experience people don’t understand what they bought and in some cases may not even know they own a variable annuity.
The basic concept of the variable annuity is sound. Provide future income while protecting your nest egg. That’s everybody’s goal for their retirement. But keep in mind there are proven investments that have worked just as well or better over long periods of time, without the drawbacks. When considering an annuity you must weigh the downside, the alternatives and the risk of annuities in your own situation. Here are a few of the drawbacks to purchasing a variable annuity contract:
High Cost. This is the big one. A big part of how successful your annuity will be still depends on the return of the stock market and the other investments in your annuity. Fees kill your return and annuities have lots of fees. First, there is a one time commission to the agent. It can be as high as 6 to 8% of your investment. Second, are the fees you pay to the insurance company every year. These mortality and administrative fees typically are in the 1 to 1.5% per year area although they can be higher or lower. The sub-account fees are the separate annual fee you pay for each investment within the variable annuity. These fees are typically in the 1 to 1.5% range but can be higher or lower. The last fee is the kicker. Riders are any additional features you want with you annuity. Any riders you have such as return of premium, guaranteed income or inflation protection have a separate annual fee. They can be around 1% per year more or less depending on the riders you choose. So for example, if your annuity earns 5% in a year and you are paying 1% for administration, 1% for sub-account fees and 1% for a guaranteed income and other riders your net earnings for the year would be only 2%.
The Fuzzy Promise of Guaranteed Income. As I mentioned above one rider you can get (at extra cost) is a guaranteed income rider. As good as that sounds the insurance company is really paying you back with your own money. Although they have to pay you “income for life” chances are they will never have to use their money. Also the “guaranteed” amount of income many times is quite low, only available under certain conditions and sometimes for a limited time period. And if you take out more than the monthly guaranteed amount that will usually reduce your future payments.
Payments Are Not Inflation Protected. Any guaranteed income you receive is a set amount for a long period of time. Inflation will erode the buying power of your fixed payment. But of course you can purchase and inflation rider for extra money every year.
Not So Tax Advantaged. A big selling point to variable annuities is that they offer tax deferred growth on any earnings until you take the money out. Sounds good right, who wouldn’t want that? What they don’t tell you is that if you take out those earnings they are taxed at ordinary income tax rates. If you had the money in regular mutual funds any capital gains would be taxed at the lower capital gains tax rate. They also don’t tell you that annuities don’t get a stepped up basis when you die. What this means is that if you pass an annuity to your heirs they would pay taxes on any capital gains you built up in the annuity from the day you first bought it - at ordinary income tax rates. If you just had that money in mutual funds your heirs would not pay taxes on any of those capital gains as of the date of your death.
Your Money Is Locked Up. Once you make the variable annuity purchase your payment is locked up except for very limited amounts at limited times. Also there are typically deferred sales charges of 1 to 8% per year for 6 to12 years after your purchase if you want to withdraw more than a small amount of your investment. The flexibility and access to your money that you would have outside of a variable annuity is lost.
Bill Oldfather is a fee-only financial planner and investment advisor. Oldfather Financial Services is an SEC Registered Investment Advisor based in Kearney NE. Email to bill@oldfatherfinancial.com