Variable Annuities
Lately, as we’ve been interviewing new clients, I’ve been seeing a lot more variable annuities in their portfolios. As should become pretty clear, I find this a disappointing reality.
Let’s begin by understanding just what these things are. A variable annuity is an insurance product that essentially wraps traditional mutual funds inside a contract. The contract can have lots of different features, but at its most basic level it is an agreement to pay the annuity owner a lifetime income, either beginning with the purchase of the policy or at some future date. How much income is paid out over time depends on how well the underlying investments perform, what additional features are tacked on to the contract, and the other ancillary costs that are included in the contract.
There are three key benefits to variable annuities. The first is that they often include some kind of death benefit, typically being at least what you’ve paid into the contract in premiums. This is helpful if the value of the underlying investments has dropped at the time of your death, and could help the contract’s beneficiary. In reality, it’s a benefit that’s rarely needed.
The second benefit is that earnings inside the annuity are tax deferred, similar to retirement accounts. This means there are no taxes due on any gains or income until funds are actually withdrawn from the annuity. The caveat here is that any gains withdrawn are taxed as ordinary income, regardless of what created the gain. With capital gains taxes rates fairly low, this isn’t terribly attractive, especially over long (20 or 30 year) time horizons. Also, like retirement accounts, annuities do not receive a step up in basis at death, potentially creating significant income tax considerations for heirs.
Finally, many states offer some asset protection to annuity contracts, similar to IRAs and 401k accounts, so that they may be more difficult for creditors to access.
The most common complaint about variable annuities, however, is that their costs outweigh the benefits. Most contracts contain multiple layers of fees that may not exist in a typical advisory or brokerage account.
Subaccount Costs. The underlying investments for variable annuities are called subaccounts. They are structured very much like traditional mutual funds, and are often managed so as to match some of the most popular or well-known mutual funds. But purchasing these funds through an annuity can be expensive. Sometimes, the annuities offer share classes that are comparable to the cheapest institutional of the mutual funds, but often the expenses are considerably higher.
Mortality and Expense Fees. This is basically the Cost of your annuity contract “wrapper”. These fees can run at the low end between 0.1 percent to 0.5 percent for “no load” annuities to as much as 2.6 percent at the high end. Ostensibly, this fee compensates the insurance company for the risks it faces, including having to pay benefits to annuity owners past their expected lifespan (mortality risk). In reality, these fees also cover sales expenses like commissions.
Annual Administration Fee. This covers recordkeeping and other expenses, and runs between $25 to 0.15 percent per year.
Rider Premiums. These cover the cost of additional features, like guaranteed lifetime withdrawal benefits. These costs are variable, though I’ve seen riders add as much as 0.6 – 1.2 percent each.
One of the most common riders is some kind of an enhanced death benefit rider. This is often defined as either the highest anniversary value of the annuity, though others may include a minimum guaranteed return on your premium payments, too. The challenge here is that this rider can add as much as 1.15 percent to the annual cost of your annuity. It’s designed to protect the value of your investment if you are unfortunate enough to die during a market downturn, but over 20 or 30 years, this rider can cost more than it would provide as an insurance benefit.
Ultimately, one of the few things over which you have significant control in investing also happens to be something which has a huge impact on your results: fees. Keeping costs down is critically important in investing, and the high costs imposed by variable annuities ultimately make them a very poor choice for long-term savings.
This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director and chief investment officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.
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