Variable Annuities (VAs) have been very popular for about a decade now, ever since the tech bubble burst. Unfortunately, their popularity may be due to brokers’ commissions of 4 to 8%, and the fact that the benefits are not clearly understood by clients or many of those that sell them. I think their biggest draw is that they have some guarantees, and believe me, sellers tout those guarantees. Unfortunately, those guarantees are not quite what people think they are.
Annuities may seem complicated, especially if you read their prospectuses, but the basic structure is simple. An insurance component provides a death benefit allowing the product its tax-deferred status. You invest among a menu of mutual fund-like subaccounts and withdrawals of earnings are taxed as regular income. There’s a 10% tax penalty on withdrawals before age 59 1/2.
You may have heard from those selling the products or friends that have bought them of 5 or 6% guaranteed returns. Those guaranteed returns are not what you think of when you think of guaranteed returns. The value of your account doesn’t go up like that. What happens is that the hypothetical value of the account that you can annuitize rises so that the amount of income you can draw on it hypothetically goes up like that. That might sound good, but there are some real problems with that.
The first is that you can’t actually take that increased amount out if you want to transfer it. You can only transfer the real value of the account based on the performance of the mutual funds. So the “guaranteed returns” are not the same as we would generally think of when we think of “guranteed returns.” They aren’t CDs.
The second is that the sellers of the products always recommend that you don’t annuitize the product. So you can never actually receive that benefit anyway. The cynic in me might suggest that they don’t want you to annuitize so they can sell you a different annuity once the 10-14 year surrender charge period goes away, and make another commission, but that’s just me.
The third is that if you get past these first two hurdles and then for whatever reason, need to take out more than that guaranteed income amount, all bets are off as far as your future guarantees.
Other problems are that the fees tend to be very high – often in excess of 3-4% of your assets annually.
Meanwhile, the much-touted death benefit isn’t likely to be worth much. According to LIMRA International, an insurance research group, only three of every 1,000 variable annuity contracts are surrendered because of death or disability.
Taxes are another shortcoming. When money comes out, it is taxed as income at rates of up to 35%. Compare that with the top rate of 15% on most long-term capital gains and qualified dividends in taxable accounts. While the tax advantage for mutual funds may be partially offset by tax-deferred compounding within a VA, it could take many years of tax-deferral for a VA to come out ahead.
There’s also the tax treatment of inherited VAs. Your heirs are subject to tax at income rates on withdrawals. In contrast, the tax basis of an inherited mutual fund is stepped up to its value when it passes to your heirs, so that gains you earned during your lifetime aren’t taxed at all.
Finally, if you experience buyer’s remorse, you’ll probably have to pay a surrender charge of as much as 7% to get your money back. While VAs may be right in some circumstances, those circumstances occur much less frequently than variable annuity sales do.
There are some companies, like Ameritas, Vanguard, Schwab and Jefferson National, with good low-cost products that don’t charge commissions and don’t have surrender fees. These companies also don’t throw around gimmicky “guarantees.” Unfortunately, in 13 years in this business, I can’t remember a potential client walking in with one of those products.