Variable Annuities: Are they for you?
With the disappearance of pensions in our society, the appeal of income-for-life offered by annuities has resulted retirees and pre-retirees pouring over a trillion dollars into annuities. For some people, these products are appropriate. Unfortunately, for many people sold these products by aggressive salesmen, an annuity is not appropriate. The problem is that these are complicated products, yet the salesmen make a simple, appealing pitch: Grow your money tax-deferred, earn a guaranteed rate of 6% with guaranteed income for life. The devil is in the details.
Annuities are insurance products, not investment products. The purpose of buying insurance is to reduce risk. Insurance decreases your individual risk, and transfers the risk to the insurance company. With life insurance, the insurance company wins if you live a long life; with a variable annuity, the insurance company wins if you die young.
Guaranteeing lifetime payments puts the insurance company at risk that you may live a long life, and therefore charge extra fees to compensate for the risk. In “annuity parlance” this fee is called a “mortality fee” and is usually combined with an expense fee paid to the insurance salesman who sold you the policy so the combined fee is called a “mortality & expense” fee. Insurance companies may call it by another name, and it may not be specifically called out on your statements, but is always subtracted from the returns you get from your underlying investments in the annuity.
In addition, there are other fees you are likely to pay for other features. A popular feature is a “Minimum Guaranteed Income” rider, where you will be charged a fee sometimes called a “living benefit” fee. This feature guarantees the annuitant a minimum monthly payout regardless of the performance of the account investments.
During the first several years after contributing to an annuity there is also a hefty “surrender charge”, which is a percentage of an amount withdrawn, usually starting at about 8% in the first year and gradually declining to 0% in 4 to 8 years.
Finally, in the case of a variable annuity, where the growth of your account is dependent on the stock markets, you will only get to select from the insurance company’s proprietary products (i.e. mutual funds) that have higher than average fund management fees. These higher fees are due in part to the fact that the salesmen receive a commission for signing you up for the fund.
Adding all the fees together makes it very difficult for your deposit(s) into an annuity to earn average market returns. Hence, my earlier statement that you shouldn’t buy an annuity as an investment. Using an example of a recent variable annuity we analyzed for a client, the mortality fee was 1.65%, the living benefit fee was 1.1%, and the mutual fund fees were 1.1% for total fees of 3.85%. Burdened with these high fees, the account earned a meager 1% compared to 8% in a popular low-cost mutual fund holding 60% stocks and 40% bonds.
Now what about the three claims in the sales pitch:
Tax-deferred growth: Any earnings in the account are tax-deferred, but when you receive the income, it’s taxed at the higher ordinary income, even if the earnings are from dividends or capital gains.
Guaranteed 6% return: This return is not on your account. In my example above, the 1% return is all you get if you liquidate the account. The 6% gain is on a “phantom” base account, which is used to calculate your annuity income if you choose to annuitize, and guarantees the annuitant that base level if the investment account is less than the base account.
Guaranteed lifetime income: Yes, the income is paid until you die, but there is nothing left for your heirs whenever you do die.
Bottom line: If you will have no guaranteed income stream in retirement other than social security, do not need access to your money for several years, expect a long life, and are willing to pay the fees associated with a variable annuity, then you may want to shop for a variable annuity, but make sure you read the fine print before signing on the dotted line. Do not even think about buying an annuity within an IRA, 401(k), 403(b), or 457 retirement plan since these accounts are already tax-deferred, so there is no added benefit.