I’m asked this question from time to time. The most recent incident was by a friend whose “financial guy” was pushing her to invest a substantial portion of her investable assets into a variable annuity that was “coincidently” offered by his employer. This friend asked me a simple but thought provoking question: What type of person is a variable annuity a good product for? Let’s analyze this question.
What is a Variable Annuity?
Investopedia defines a variable annuity as follows: “An insurance contract in which, at the end of the accumulation stage, the insurance company guarantees a minimum payment. The remaining income payments can vary depending on the performance of the managed portfolio.” Money invested in a VA grows tax-deferred just like a Roth IRA (note VAs are often the vehicle used in 403(b) plans and can be used in an IRA, but for purposes of this article we are only discussing after-tax, non-qualified accounts). At some point in the future the money can be withdrawn either in a stream of payments (annuitized) over a variety of time frames with varying payouts for a survivor if applicable, withdrawn all at once, or in partial withdrawals over time. Generally the amount contributed is not subject to taxes, the gains are subject to taxes at ordinary income rates.
Who should consider a Variable Annuity?
I generally counsel most people to fully fund their company retirement plan such as a 401(k) first, their next priority should generally be funding an IRA (traditional, Roth, or after-tax). This prioritization is general and certainly one size does not fit all. For example a variable annuity might be more attractive to someone who is looking for an investment vehicle where gains can grow tax-deferred and whose 401(k) plan is lousy. 4 Signs of a Lousy 401(k) Plan include:
- A plan investment menu loaded with proprietary funds offered by the plan provider.
- A fund line-up consisting solely of funds from a single fund family.
- A line-up consisting of funds with high expense ratios.
- A plan that is wrapped in an insurance company group annuity plan.
Additionally if your plan doesn’t offer a match in addition to having one or more of the above characteristics a variable annuity might be attractive to you. A variable annuity can serve as an additional leg on your retirement planning stool. For example you might have a 401(k) plan, an IRA, taxable investments, Social Security, and possibly a pension. A variable annuity can offer another vehicle for tax-deferred investment growth.
Expenses are a key factor
As an insurance product all variable annuities have an insurance cost as well as the expense ratio of underlying investment sub-account. The cost of two otherwise similar variable annuity products can vary widely. For example the annuity this friend asked me to review carried expenses that were in excess of 2% all-in for most of the sub-accounts. This notation on the Vanguard site illustrates the wide variations in VA costs:
“* Source: Morningstar, Inc., as of December 2012. The Vanguard Variable Annuity has an average expense ratio of 0.58%, versus the annuity industry average of 2.28%; excludes fees for optional riders. Actual expense ratios for the Vanguard Variable Annuity range from 0.46% to 0.79%, depending on the investment allocation. The expense ratio includes an administrative fee of 0.10% and a mortality and expense risk fee of 0.195%. The expense ratio excludes additional fees that would apply if the Return of Premium Death Benefit rider or Guaranteed Lifetime Withdrawal Benefit rider is elected. In addition, contracts with balances under $25,000 are subject to a $25 annual maintenance fee.”
Additionally many VAs offer additional riders or contract features such as the Return of Premium Death Benefit Rider mentioned above. In all cases you should evaluate the cost of any riders and the benefit you would derive and then relate this to your unique situation when evaluating a given VA product. The VA that I was asked to review also had a surrender period. What this means is that for a period of time (either 10 or 7 years in this case) you will be charged a penalty if you surrender the contract (in English this means withdraw your money). While the insurance company might argue that this is needed to provide them with stability or some other mumbo jumbo, the fact is that you would be charged a hefty (especially in the early years of the contract) fee even if you found a better variable annuity and wanted to move your money to that product. The surrender charge declines over the life of the surrender period and you can withdraw a small portion of your money without penalty each year. I strongly urge you to find a VA (such as Vanguard’s or several others) with no surrender charges.
Most VAs utilize sub-accounts that look like mutual funds, but aren’t. For example the sub-account might have a name like the XYZ Annuity Fidelity Contra sub-account. While the sub-account might invest in shares of the Fidelity mutual fund with the same name, or might even be managed by Contra’s manager this is not the Fidelity Contra fund. If for no other reason than the higher annuity expenses, the returns will be different (and generally worse). Just like any investment vehicle the quality of the investment options and their expenses should be a key factor in evaluating a given variable annuity and even whether to invest in a VA at all.
Is a variable annuity the right choice for you?
As with much in the realm of financial planning and investing, the answer is “it depends.” In addition to what we’ve discussed above, ask yourself these questions:
- What does a variable annuity do for me that I can’t accomplish with investments outside of a VA?
- Will I annuitize the contract or take periodic withdraws?
- Do I already have enough annuitized retirement income from Social Security and a pension?
- Do the benefits of the VA I’m considering outweigh the expenses?
- Why is my “financial guy” really pushing this VA?
- How sound is the insurance company behind the product? Do I understand what happens and who I might turn to if the insurer encounters financial difficulties?
- VA gains are generally taxed as ordinary income, how does this fit with your retirement tax strategy?
- VAs can trigger some estate planning issues, make sure that you understand these and are prepared to plan accordingly. These include both tax-related issues and the fact that any money that is annuitized becomes unavailable to pass on to your heirs upon your death.
A variable annuity can be an appropriate tool in your retirement planning toolkit. Just make sure that you understand what you are looking to buy, why you would be buying it, and ALL of the underlying expenses involved.
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