Investor pro tip: most investments that are pitched along with a free steak dinner deserve more than a quick once over before you sign on the dotted line. Chances are those investments work out better for the one selling them than they do for the one buying them. Variable annuities fit squarely in this framework and in this month’s post, we’ll take a look at some reasons why they aren’t a good fit for most investors.
First an overview on annuities. Annuities in their most basic form, are contracts with an insurance company that offer a guaranteed stream of income in exchange for one upfront payment or a series of payments during the “accumulation phase”. The resulting income stream can be structured in a multitude of ways. Payments for a certain period of time or for a single or joint lifetime are all possible.
Annuities are then grouped between fixed and variable annuities. Fixed annuities offer a guaranteed rate of growth and protection of principal along with the income stream just described. Variable annuities, however, are invested in underlying funds that are subject to all of the same types of investment risk as funds outside of an annuity. There are no guarantees associated with the funds within a variable annuity. Same goes for the stream of income from a variable annuity. These payments to the contract owner may be guaranteed to last a certain period of time but there is no guarantee on the amount of each payment. These too are tied to the performance of the underlying funds. You would think that because there are no guarantees tied to the underlying funds, the contract fees should be pretty low, right? Well, if you thought that, you’d be wrong.
Variable annuity contracts are riddled with fees, and with so many different terms, it can be tough to keep track of them all. The first fee charged by the insurer is the Mortality and Expense Risk Charge. That’s right, the insurance company is charging you for the risk that you’re bearing! Next are the Rider and other features charges range between 0.25% and 1% depending on the selections made. More than one selection can be made here, and you’ll pay for each “benefit” that’s been tacked on to the contract! Then there are the underlying fund expense fees. These typically range between 0.6% and 3% per year. Adding all these fees up leaves us averaging around 2.3% to 3% per year!
Now let’s say that once you got a handle on all of these fees, you’d like your money back and to get as far away from the salesman as you can. Not so fast, these annuities also come with surrender charges. Depending on the insurer, these can run up to 10% if you’d like your money back in the first few years of your contract!
Variable annuities do offer tax deferred growth on the investments within the annuity but even the SEC has advised that:
“For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity.”
This tax deferred growth can be a benefit for non-qualified money, but it’s important to understand that you will face a 10% penalty for withdrawals before age 59 ½ and the deferred taxation turns what would have been capital gains into ordinary income when you begin withdrawals. Also, you don’t get double benefit for money that’s already in an IRA and then rolled into an annuity!
While these types of contracts are incredibly complex (purposefully, it would seem) and they are a fit for a very limited group of investors, annuities aren’t all bad. Constructed correctly, they can be a vital part of your overall portfolio and retirement income outlook. When reviewing annuities, simplicity is key. Know what you are paying for and why you are paying for it. There are products like fixed and fixed indexed annuities that offer true principal protection without the confusing – and expensive – bells and whistles that variable annuities can become laden with.
Reviewing annuity contracts can be a daunting task but we’re here to help. If you have or are thinking of purchasing a variable annuity and would like a second opinion, please reach out to us at Innova Wealth Partners.
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