Insider’s Guide To Variable Annuities
It has always been fascinating to me why this segment of the securities business has been so successful.
I think it is a testament to the ability of a security salesman to focus on the perceived benefits and only mention the downside in passing. I know all about the need for transparency and the rules governing the sale (prospectus), but the question that pertains to me is simple: Why would anyone buy a variable annuity? (VA)
I know all the answers because I have heard them. Many times I have asked a prospect why they purchased a VA, the answers are underwhelming. “I thought I was buying an income stream; I didn’t know about the fees. I didn’t realize I could lose money. I have always followed my broker’s advice.” And my favorite…..”His assistant always brought me a latte!”
Whatever the actual reason for the decision to buy a variable annuity is, the simple answer is this: If a prospect understood precisely how a variable annuity worked, there would not be a chance in heck anyone would ever buy it.
A little background about annuities: In the annuity world, there are two different classes of annuities, variable (securities) and fixed (insurance).
Another way to think of variable annuities is as opposite from fixed annuities. (FA) A FA is Market Safe, and a Variable Annuity (VA) is at Market Risk.
Two completely different products whose only real association or link is their common surname: an annuity. Our products (FA) are sold by insurance agents licensed by their state department of insurance, variable annuities are sold by security salespeople, and authorized by a national agency that regulates securities.
How does it all add up? It’s Safety. It is essential to know if the annuity you’re buying is safe. Here is the all-important question to ask: are all annuities safe? An FIA is built on safety and security while a VA is built on risk. Simple.
A nationally known financial expert, Jane Bryant Quinn (http://janebryantquinn.com/)
She recently said in the Wall Street Journal: “I would like to take all variable annuities and smash them to smithereens.” And she is not the only high-profile financial expert to make such strong claims. Experts see variable annuities for what they are, overpriced, high-risk, expensive securities sold as safe and secure; I assure you they are not.
The lingering question about the success of variable annuities as a sales vehicle is on the surface, difficult to understand. By scrutinizing it and using the “new car” concept of selling, the focus is on the allure, the new paint, the transformation of us as drivers being behind the wheel, and on it goes. Security salespeople focus on those points, at least that is the only possible answer that I can understand because once you take a serious look under the hood and understand precisely what makes things work, a new car would NOT be in your future.
Think of a variable annuity as a magic basket, a basket that holds your eggs. In actuality, the eggs are your investments. This basket can expand and contrast as needed, it can contain different types of investments, and it can also have handles placed on the basket. This magic basket’s handles are called riders, riders to provide income, increase death benefits (life insurance), and other benefits. Inside the basket are your eggs, your investments. Your investment options can vary between stocks, bonds, real estate, and numerous other choices. Plus in this magic basket, you can change your eggs (investments) as often as you wish.
The basket is not magic, and it does exist, it is called the annuity wrapper. The issuing company provides the basket and charges you a fee to maintain it. The fee is based on the overall value of your total investments, and it can vary in cost from 1.25% to higher (or lower). This expense is annual and ongoing.
The eggs in the basket are called sub-accounts which is similar to a mutual fund. The sub-accounts are separate and distinct; each sub-account is managed by a company that also manages mirrored mutual funds. To be more direct, when you buy a sub-account you are buying the mutual fund. Sub-accounts are investments, investments in whatever the fund is designated to invest in, for example, it could be Foreign Bonds or Small Cap Growth Funds or US Treasuries, the actual option for investment is wide and varied. The number of sub-accounts (investments) offered in a variable annuity is also wide and varied from a few choices to more than 300 based on the variable annuity. Sub-accounts can be built into a portfolio to attempt to reach an individual’s goals.
The trouble with sub-accounts? Two simple words: fees and risk.
A sub-account is an investment, investments can go up or down, this is the second part, and they are a risk. The first part is the fees associated with the sub-account; the fees are annual and are based on the value of the sub-account. The fees are also wide and varied and can range from .25% to 4% of the value of the sub-account. Plus the sub-accounts are also subject to fees and expenses charged by the fund management when assets are bought and sold within the sub-account.
So much has been written about variable annuities, both good and bad. Major financial publications such as The Wall Street Journal have railed against variable annuities. One article “Are Variable Annuities Safe” examines both sides of the argument but considers the benefits relating to the fees and expenses as being a poor decision.
The fee problem is easy to explain when you know the actual workings of a variable annuity. It boils down to one simple fact: The funds in a variable annuity are not at the insurance company, the funds are invested away from the insurance company at the individual sub-account. The insurance company cannot use the invested funds to make money other than to charge a fee.
According to the national leader of reporting financial fees, Morningstar, the average fee for variable annuities is 3.61%, and this would not include and handles on the basket (riders).
The 3.61% is for the basket and the sub-accounts. Riders added to the variable annuity would be another fee and expense on top of the basic expenses.
Riders added to variable annuities can provide a myriad of benefits, increased death benefits, income guaranteed, long-term care, and much more. Unless you know for certain your plans for the eventual use of a variable annuity, adding riders that charge fees can add up in the expense column.
Have a look at what a 4% expense fee can mean to long-term accumulation, using the historical S&P Stock Index.
Fees Can Greatly Impact Results: 4% per Year Fee.
Does a 4% fee sound too high, the truth is simple; 4% is nearly the national average of an annual fee for a variable annuity, not including riders.
Once you have decided to buy your “basket” added your sub-account investments, you will be faced with the “rider” options. While there is nothing wrong with adding riders, you are sure you will use, adding those riders as a “possibility” of their use can be another expense subtracted from your account value.
Fees for riders such as extended death benefits and guaranteed income can vary wildly based on the product you selected and your age. As an example, it is considered average to add .75% to 2.00% in additional fees when an income rider is selected. The simple cost of the rider needs to be accurately accounted for and compared to any desired result. The actual expense can be devastating to any account growth.
A popular rider is the guaranteed death benefit rider which assures the beneficiary of the VA will receive a fixed and guaranteed amount at the death of the annuitant. What is often overlooked is just precisely how this benefit is calculated. If the VA has a guaranteed death benefit of $100,000 (example), and the actual cash value of the VA is $75,000, then the amount covered by the death benefit rider is $25,000. The $100,000 is paid in a lump sum, but in reality, $75,000 was the actual value of the cash in the contract.
Fees for a death benefit enhancement rider can be high, always ask and compare before selecting this rider.
Questions to consider asking your broker about variable annuities:
- What is the purpose of the variable annuity? What do you want to accomplish?
- Are you investing in the variable annuity through an IRA?
- What might happen to your retirement income should your account value decrease?
- Do you understand the features of the variable annuity and the costs associated?
Do you understand the surrender penalties when you consider a long-term commitment?
- Are there features of a rider attached to a variable annuity, such as increased death benefit, that provide a benefit that may be less expensive if purchased separately?
- If you are exchanging one annuity for another one, are you using the IRS 1035 rules for a tax-free exchange?
- Information is the key to success, the more you learn, the more options for success. Annuities can be the perfect vehicle for use as a retirement vehicle, make sure your choices of a product make sense for your goals.
Information is the key to success, the more you learn, the more options for success. Annuities can be the perfect vehicle for use as a retirement vehicle, make sure your choices of a product make sense for your goals. Always seek competent and authorized advice from a licensed professional before making any important decisions.