Would another column criticizing variable annuities (VAs) be like kicking a man when he’s down? VAs have come under a barrage of criticism. Recently, financial columnist Jane Bryant Quinn said she’s so “deeply angry at this common investment product that I dream of blowing it to smithereens.” The SEC and NASD have instituted dozens of enforcement actions against variable annuity purveyors for deceptive sales practices. Class action lawsuits have been filed against various brokers challenging fraudulent variable annuity sales practices.
Despite widespread criticism, sales of VAs remain brisk, rising strongly since 2002. Assets held in VAs are now at record levels, well north of $1 trillion. How can something so loathed by so many knowledgeable people seem so popular with the investing public?
Let’s start by defining some terms. Traditionally, an “annuity” was a financial contract between an insurer (the issuer) and the annuitant. The annuitant paid a lump sum premium to the issuer, and the issuer promised to make a series of payments to the annuitant for a specified number of years or over a lifetime. This is now called an “immediate annuity.”
A shrewd insurance company came up with the idea of a “deferred annuity.” Instead of an immediate income stream, the annuity payments were deferred, and the annuity premium was invested so that the annuity payments, once they began, would be larger. This contract was linked with an insurance policy, allowing income taxes on the investment gains during the “accumulation period” to be deferred.
Then, an even shrewder insurance company realized it could let the contract holder select how the funds would be invested during the accumulation period. The contract value reflects the performance of the underlying investments held in a number of investment portfolios of stocks, bonds or money market accounts, minus the contract expenses. By letting the contract holder select the investments, the insurance company is able to lay off all the investment risk on the contract holder, including the potential loss of the principal invested. Thus was born the “deferred variable annuity,” now simply called the “variable annuity” or “VA.”
Few investment options are more expensive than a VA, which typically has two levels of expenses. The first is a charge for “mortality and expense” (M&E), which usually runs from 1.1 percent to 1.4 percent of the VA account balance annually. Then there are “separate account expenses” that apply to each investment portfolio within the VA, often exceeding 2 percent annually.
Those hawking VAs cite two primary benefits: tax deferral and insurance. Typically, the issuer promises that, at your death, your VA will be worth at least what you paid in, less any withdrawals you made—but this benefit is illusory.
Say you buy a VA for $100,000—how much insurance do you have? Answer: none because your account is worth $100,000. If through poor performance or unfavorable market conditions, your VA account declines in value, the death benefit covers only the gap between your account value and the initial premium you paid. The M&E charges apply to the entire VA balance even though the death benefit may represent only a small fraction of the account value. Of course, if your account balance exceeds what you paid in, you are charged M&E even though there’s no death benefit. According to South Florida Sun-Sentinel columnist Humberto Cruz, it’s an “open secret” in the industry that the seller’s commission, not the death benefit, accounts for the bulk of the typical VA mortality and expense charges.
And remember, it is only your beneficiaries, not you, who might benefit from the insurance in your VA some day.
The tax deferral features of a VA are also usually of little or even negative value. Compare a VA to a low-expense, tax-efficient mutual fund. While it’s true the mutual fund will generate some ongoing taxable dividends, the taxes on those dividends will almost certainly be less than the annual expenses of the VA.
Later, if you want to cash in your mutual fund, any increase over what you paid for it will be treated as capital gain, which, if held more than a year, will be taxed at a maximum federal rate of 15 percent. In the VA, any gains remain ordinary income. In effect, the VA converts tax-favored dividends and capital gains into ordinary income.
At your death, your heirs will inherit your mutual fund (or other appreciated property) on a “stepped-up basis.” They can sell the fund without recognizing any gain for tax purposes. Your VA heirs, by contrast, receive your basis and must pay ordinary income tax on your investment gains.
Then there are surrender charges. The typical VA imposes surrender charges for seven or more years from purchase, typically starting at around 8 percent of the amount redeemed. Because of high VA expenses, investors would generally do better to cash in their VAs, pay the surrender charges and invest the difference in a low-cost, tax-efficient mutual fund. However, people view surrender charges like they view taxes—they don’t want to pay them unless they have to. So VA investors tend to sit tight at least until the surrender charge period passes.
In summary, from an investor’s standpoint, VAs are illiquid, expensive and offer tax deferral and insurance benefits that are mostly illusory. But for the issuer, VAs are a dream come true, generating steady revenue streams from the high fees while relieving the issuer of most risk. So the investing public ends up buying VAs from which they receive meager benefits from issuers that reap outsized rewards in a lucrative commission system that pays the selling bank, broker or insurance agent from 5 percent to 8 percent of the premium.
If you’re locked into a VA with an obnoxious surrender charge, what should you do? Many VA contracts let the holder withdraw up to 10 percent of the initial premium each year without penalty. If you can, take advantage of this feature. If you’re not confident about your ability to invest what you withdraw from your VA, you’ll almost certainly do better than you’re doing now if you put the proceeds into a low-cost index fund.
And if you’re considering a VA as an investment option, remember the advice about VAs in a recent Kiplinger article: Don’t let the bells and whistles distract you.
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This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
