Variable Annuity Basics
Click here to download the following as a PDF
Variable annuities have become an increasingly popular option amongst many commissioned advisors when planning for retirement for clients. The purpose of this paper is to discuss some of the basic concepts of variable annuities and discuss important features along with their relative cost.
A variable annuity is technically an insurance product structured to make “guaranteed” periodic payments beginning immediately or at some future date. There are two phases to an annuity, the accumulation phase, and the payout phase. During the accumulation phase, payments are made into the annuity and invested in a limited selection of mutual funds made available by the insurance company. In addition to “guaranteed” payments, a second advantage of annuities is that earnings will grow tax-deferred until withdrawn.
In the payout phase, the annuity owner will select a payment option and the insurance company will make periodic payments as agreed until the annuitants’ death or some specified period of time.
Annuities may also offer a death benefit should the owner die before the payout phase begins. Usually, the death benefit is equal to the amount of money originally invested into the contract. The insurance company may offer “step-up” options that will adjust the death benefit at certain intervals in order to “lock-in” potential gains from the investments. In addition to the general features described above, some annuities offer other benefits such as guaranteed minimum income benefits or long-term care insurance.
While the features of variable annuities make them seem an attractive alternative in retirement planning, it is imperative to explore the cost of such features and whether there are more appropriate alternatives. The major cost of an annuity is the mortality and expense risk charge that pays for the insurance risk and sales commission. This charge will normally range from .75% to 1.75% annually of the account value. In addition, the mutual fund alternatives within the annuity will also levy a management fee that can range from .5% - 2% of the amount invested. On average, these fees alone can total 2-3% of the amount invested. Furthermore, other “guaranteed” benefits or riders attached to the contract may also carry additional charges, which will increase the overall cost of the investment and further reduce the net long-term return.
Since insurance companies normally pay the commission on an annuity sale upfront to the salesman, it has to recoup this payment in the form of a surrender charge should you decide to withdraw from the contract during the surrender period. A typical surrender charge schedule will start around 6% and decline to zero over a specified period of time, usually 4-10 years. Should you become unsatisfied with the performance of the annuity or need the money unexpectedly, it could be costly to withdraw your money.
While tax deferral is an attractive feature of an annuity, other investment vehicles, such as an IRA or 401k, offer tax deferral and should be utilized before investing in an annuity. Too often, annuities are held inside an IRA account. There are no additional tax advantages to purchasing an annuity within an IRA since the earnings in an IRA grow tax-deferred anyway.
When used outside of an IRA, it is still important to examine the tax characteristics of an annuity since the earnings withdrawn are taxable at normal income tax rates. If the investment is planned for more than one year, earnings may be taxed at the current maximum rate of over 35% versus the current maximum long-term capital gains rate of 15%. In effect, an annuity buyer is converting long-term capital gains into ordinary income. A second tax detriment is that earnings withdrawn prior to age 59 ½ will be assessed a 10% penalty by the IRS.
Therefore, before investing in an annuity, you should seek full disclosure of all charges and fees and understand how these fees will affect the long-term performance of your investment. While annuities appear to offer attractive features, it is important to explore each feature and decide whether there is a better or more cost effective solution elsewhere. For more information or questions you should ask before investing in annuities, visit the Securities and Exchange Commission’s website at http://www.sec.gov/investor/pubs/varaquestions.htm or call us at 504-835-1135.