Variable Annuity Investments
What Are They?
Although variable annuities offer investment features similar in many respects to mutual funds, a typical variable annuity offers three basic features not commonly found in mutual funds:
- Tax-deferred treatment of earnings;
- A death benefit; and
- Annuity payout options that can provide guaranteed income for life.
Generally, variable annuities have two phases:
- The "accumulation" phase when investor contributions - premiums - are allocated among investment portfolios - subaccounts - and earnings accumulate;
- The "distribution" phase when you withdraw money, typically as a lump sum or through various annuity payment options.
If the payments are delayed to the future, you have a deferred annuity. If the payments start immediately, you have an immediate annuity.
As its name implies, a variable annuity's rate of return is not stable, but varies with the stock, bond, and money market subaccounts that you choose as investment options. There is no guarantee that you will earn any return on your investment and there is a risk that you will lose money.
Evaluating Variable Annuities
The variety of features offered by variable annuity products can be confusing. For this reason, it can be difficult for investors to understand what's being recommended for them to buy especially when facing a hard-charging salesperson.
Before you consider purchasing a variable annuity, make sure you fully understand all of its terms. Carefully read the prospectus. Here are seven factors you should bear in mind before investing:
Deferred variable annuities are long-term investments. Getting out early can mean taking a loss. Many variable annuities assess surrender charges for withdrawals within a specified period, which can be as long as 6 to 8 years. Also, any withdrawals before an investor reaches the age of 59 1/2 are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.
Most variable annuities have a sales charge. Like back-end (Class B) shares of mutual funds, many variable annuities shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example, a surrender charge could start at 7% in the first year and decline by 1% per year until it reaches zero.
In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses when you invest in them, such as:
Mortality and expense risk charges, which the insurance company charges for the insurance to cover:
• Guaranteed death benefits;
• Annuity payout options that can provide guaranteed income for life; or
• Guaranteed caps on administrative charges.
Administrative fees, for record-keeping and other administrative expenses;
Underlying fund expenses, relating to the investment subaccounts; and
Charges for special features, such as a:
• Stepped-up death benefits;
• Guaranteed minimum income benefits;
• Long-term health insurance; or
• Principal protection
These annual fees on variable annuities can reach 2% or more of the annuity's value. Remember, you will pay for each variable annuity benefit. If you don't need or want these features, you should consider whether this is an appropriate investment for you.
While earnings in a variable annuity accrue on a tax-deferred basis -- typically a big selling point -- they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains, but allow your contributions to reduce your current taxable income. That's why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans.
Once you start withdrawing money from your variable annuity, earnings (but not principal) will be taxed at the ordinary income rate, rather than at the lower capital gains rates applied to investments in stocks, bonds, mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year.
In an attempt to attract investors, many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity, generally ranging from 1% to 5% for each premium payment you make. Bonus credits, however, are usually not free. In order to fund them, insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods.
Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens.
Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.
Also, if the annuity is within a traditional (rather than a Roth) IRA, the government requires that you start withdrawing income no later than the April that follows your 70th birthday, regardless of any surrender charges the annuity might impose.
Beware of High Pressure Sales Tactics
The marketing efforts used by some variable annuity sellers have recently been under strict scrutiny by regulators. Sales pitches for these products might attempt to scare or confuse investors. One scare tactic used with seniors is to claim that a variable annuity will protect them from lawsuits or seizures of their assets.
Seniors appear to be frequently targeted, with 90-year-olds sometimes sold variable annuities whose withdrawal penalties last for 10 years or more.
A FINRA report found that firms repeatedly go back to the same customers and switch them to a new variable annuity product every few years. The broker will suggest that you switch to a "better" variable annuity in a tax-free exchange. However, it is not disclosed that you will have to hold the variable annuity for many more years before you can touch your money penalty-free. In 2004, the FINRA brought an action against a broker for switching 6,700 customers to a new annuity that earned the broker higher fees. 1,400 customers were likely to lose money on the trade, while the broker made $37 million in commissions, according to the complaint.
In a complaint received by the SEC, the purchasers of a variable annuity were advised that having an annuity as part of their tax-deferred investment account (IRA) was the same as a "double tax-deferred investment." While it's true that one key benefit to purchasing variable products is that earnings on the investment accumulate tax-deferred, a variable annuity within a tax-advantaged account will provide no additional tax savings. It will, however, generate fees and commissions for the broker.
How to Protect Yourself
Brokers recommending variable annuities must explain to you important facts, including:
- liquidity issues, such as potential surrender charges and 10% tax penalties;
- fees, including mortality and expense charges, administrative charges, and investment advisory fees; and
- market risk
Brokers also must collect important information from you about your age, marital status,
occupation, financial and tax status, investment objectives, and risk tolerance to assess whether a variable annuity is suitable for you.
Before purchasing a variable annuity, you should specifically ask the person recommending that you purchase a variable annuity:
- How long will my money be tied up? Are there surrender charges or other penalties if I withdraw funds from the investment earlier than I anticipated?
- Will you be paid a commission or receive any type of a compensation for selling the variable annuity? How much? What are the risks that my investment could decrease in value?
- How much are the fees? Variable annuities have high commissions, typically above 5 percent. The annual fees on variable annuities can reach 2 percent or more of the annuity's value. So do not sign any paperwork until you know exactly what fees and expenses you will have to pay
And remember to ask yourself:
- Am I already contributing the maximum amount to my 401(k) plan and other tax-deferred retirement plans?
- Do I have a long-term investment objective? Am I going to need the money before the surrender period ends (usually at least 7 to 10 years)? Will I need the money before I'm 59?
- Do I understand how the variable annuity works, the benefits it provides, and charges I have to pay?
- Have I read and understood the prospectus?
- Are there special features provided such as added long-term care insurance that I don't need?
- If I've decided to purchase a variable annuity, have I shopped around and compared the features of various variable annuities, such as sales loads and other fees and expenses?
- If I'm being told to purchase a variable annuity or variable insurance as part of my IRA, Keogh or some other tax-deferred retirement account I should remember those products already have a tax advantage.
- Do I have enough money right now to purchase this product? It's dangerous to mortgage my home in order to purchase a variable annuity or variable life insurance product.
- Am I being pressured into making a quick purchase?
Have You Already Purchased a Variable Annuity? Some policies may have a "free look" period that allows you to cancel within a specific period.