Ahh, variable annuities. An investment touted by some (typically advisors) as the greatest investment ever, and by others as the worst.
Well my friends, there’s a reason the variable annuity is talked on so much, and it isn’t simply because of how great it is. Really, the reason you hear so much about it, is because it’s controversial.
But before I give you an answer on who the variable annuity is designed for, let’s look at a little background on how the variable annuity came about and what exactly a variable annuity is.
Taken from SEC.gov:
A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.
So, what does that mean?
I like to think of a variable annuity as a piece of candy. Yes, candy. When you receive a bite size piece of candy it has a wrapper, and then inside is what you’re really after, the candy.
In this illustration, the wrapper is an insurance contract, while the candy is the investment which is typically a mutual fund type of account.
Here’s a picture for your reference 😉
What is a Variable Annuity?
What insurance companies did was they created an all-in-one (as seen on tv) package that combines the characteristics of a fixed annuity with the benefits of owning mutual funds. To have this all-in-one package, the investor pays a premium to the insurance company who then buys “accumulation units” into the investors account.
Confused yet? Well, there’s more.
There’s actually two basic types of variable annuities, immediate and tax-deferred. An immediate annuity is typically used by retirees who have saved their money in other accounts and rollover to a variable annuity because they want a lifetime income. With a tax-deferred annuity, you invest your money and it can grow tax-deferred until you decide to withdraw, similar to other tax-deferred accounts you may know of.
Who are they designed for?
I’m a firm believer that there really aren’t many truly bad investments, just the right investments for the wrong people.
With that being said, there are investments that are truly only beneficial to a very small subset of people. In my research, the Variable Annuity is an investment with one of the smallest set of people it would benefit.
So, who would the Variable Annuity best suit?
- Doctor’s who are very worried about mal-practice suits. The reason? A majority of states protect assets in variable annuities from creditors, which is different from regular IRA’s which do not have ERISA protection.
- Investors who truly understand the Variable Annuity, and are willing to pay the usually higher fees associated.
- Investors who are in a job that is deemed economically hazardous. Same reason as doctor’s who are worried about mal-practice suits, your variable annuity could be protected from creditors.
- Those who believe they will live much longer than their statistical average. The income stream is based on an average, and if you live longer than that, you could beat the insurance company.
Now, there are some benefits to variable annuities.
Similar to an IRA, your contributions and earnings within the account can grow tax deferred.
Also, there is the option to have income for life once you annuitize your contract. The Insurance company will guarantee the income for you and you sometimes have the option for your spouse as well.
And finally, you have the option to change your investments when you would like. This can be both a benefit and a detriment depending on how you when it comes to risk and so forth.
There you have it, some benefits of the variable annuity. Some “financial experts” such as Suze Orman will only explain the bad of variable annuities, which do outweigh the positives, but it’s important to give both sides of the issue.
Let’s look at some negatives of the Variable Annuity:
- No matter what an advisor tells you, when you purchase a variable annuity, you are not purchasing a mutual fund. I’ve come across investors who were convinced the broker told them they were purchasing mutual funds only to call the company and realize it was indeed a variable annuity.
- FEES, FEES, FEES. Many advisors can be crafty when introducing variable annuities and gloss over the fact that the fees associated with Variable Annuities are quite high when all added up. These fee’s can include:
- Administrative Expenses – This covers the cost of mailings and providing continued service. Typically this ranges from .1% – .3%.
- Mortality Expenses – Because variable annuities are insurance contracts they charge you for a death benefit. This death benefit is typically a guarantee to pay your beneficiaries at least what you put in. The fees for M&E ranges from .5% – 1.5% usually.
- Investment Expense Ratio – The mutual fund like aspect of the variable annuity that typically trips people up has an expense. This expense is for the underlying stock and bond investments, that as explained earlier are call sub-accounts. The management fee’s for this have a wide range all the way from .25% -2% or more of the value in the account each year.
- Surrender Charges – Many variable annuity policies will pay a large upfront commission to the advisor. The surrender charge is in place in case you surrender your policy early, the insurance company can get the commission back that they paid out.
- Additional Rider Costs – Riders are essentially extra benefits that you pay for. They can give you extra guarantees or death benefits. Riders fee’s range as much as the different types available but a good idea on the costs are .25% – 1%.
- Once you annuitize your contract, there is no return. Investopedia.com has a great example of this that you can see here:
Say you put $264,000 into an annuity at age 60 and accept the insurance company’s offer to pay you $1,000 per month for the rest of your life. You will have to live until age 82 to break even on the contract. If you live past age 82 the insurance company must continue to pay you the monthly check, but if you die before you reach age 82 the insurance company keeps the remaining funds. So even if you die as early as age 63, the insurance company keeps the remaining balance of your $264,000. Many investors find this hard to swallow. Nevertheless, prior to selecting payout, they have to decide whether annuitizing will be beneficial – and, ultimately, this depends on how long they think they will live.
- The final downside isn’t exclusive to variable annuities but once you put funds into an annuity contract, those funds can not touch your hands until you reach the glorified 59.5 years old mark, or else you’ll have to pay a 10% penalty. Yikes!
In my opinion there aren’t necessarily bad financial products, just the wrong people for the right investments. Some investments have a more narrow population who could benefit from them, but nonetheless there are people who could use the investment successfully. The variable annuity is a prime example of an investment that many greatly downplay, and for good reason. However, as with anything, DO YOUR RESEARCH. Talk to advisors, get their take and then take their advice and due your own research to figure out what is best for YOU, not somebody else.
– Cooper Mitchell