Avoid Variable Annuities

Variable annuities are popular products. They shouldn’t be. Individuals generally get ripped off when they buy them. Guess who loves variable annuities? The folks who earn sizzling commissions selling the things. These retirement instruments are sold, not bought.
 
Advisors and agents howl in protest when criticized for pushing variable annuities but there are few things more lucrative then selling these products. A 7% to 8% commission split with the firm that issues the annuities still yields a tidy 3% to 4% commission for the seller. That’s $7,500 to $10,000 on a $250,000 annuity – a fee earned often with very little time or effort.  
 
Caveat emptor (“buyer beware”) doesn’t seem to apply since sales continue to grow: up 16% in 2011, to $85 billion. Advertisements that prey on retirement fears (a gorilla on a plane, elevator or elsewhere – the perils of ignoring your retirement) are very effective in tapping fears about outliving assets in retirement.
 
I regularly receive emails from annuity firms that promise substantial commissions for selling variable annuities. (Note: They don’t know I don’t sell products.) My father is a great example of a potential variable annuity victim: A financial adviser tried to sell him one a few years ago, when he was 79. My father showed the proposal to me, and I saw the surrender period was 10 years and the fees were well over 3% per year. My father would not have been able to access this annuity without penalty until he turned 89.
 
What are variable annuities? Briefly, they are a mutual fund-type of account overlaid with a thin layer of insurance. If you fund an annuity with after-tax money, all future gains are tax-deferred (and are taxed at a higher ordinary income tax rate than capital gains rates). If you fund an annuity with tax-deferred dollars, you’re not doing much except adding a layer of unnecessary fees.
 
A classic 1998 article in Forbes slamming these creatures, “The Great Annuity Rip-Off,” sums up the benefits (a handful) and drawbacks (many) of investing in variable annuities. Time has not improved the products. Some key points distilled from Forbes and previous articles that I’ve written:
 
1.      If you truly want to convert after-tax dollars and gains to tax-deferred gains, you can pour money into a variable annuity, but be aware you do not receive a tax deduction since annuities are not qualified retirement products.
 
2.      It could make sense to annuitize a variable annuity (convert your lump sum to an income stream) if you end up living a substantially longer life than the statistical average.
 
3.      Fees typically are very high – at least 2% per year, including “mortality and expenses.”  Some variable annuities cost 3% to 4% per year.
 
4.      Investment options typically are limited and often have high underlying expense ratios, meaning the fees for the funds in the plan are large.
 
5.      The insurance component is misleading. It’s not insurance in the common sense of the word. “Insurance” in variable annuities typically guarantees you’ll receive at least the amount of money you initially invested into the annuity if you die (unless you have a rider that increases the coverage, but these are rare since the 2008 meltdown). If you die suddenly, your estate gets the value of your account (if you haven’t yet annuitized). The “insurance” only has value if your investment plunged dramatically versus your initial purchase amount.
 
6.      Annuities are disadvantageous to inherit if they don’t go to a spouse. If the money formerly was after-tax dollars, the heir receives no step-up in basis on accounts with gains. (With a step-up, the value of inherited assets is readjusted to what they’re worth when the original owner died, not back when he bought them. So if the beneficiary sells the assets, their capital gain is taxed only from the new basis.) If you invest the same dollars, after-tax, in a stock fund, your heirs benefit from a step-up in basis at the date of death or nine months later. This is hard to quantify but a step-up is a powerful tool to reduce capital gains taxes.
 
7.      Disclosure to individuals – at least the clients I work with – is very poor. I typically see a lot of confusion for clients who bought variable annuities. These are complex instruments with many moving parts that aren’t always adequately explained (or even understood) by the seller. Folks who buy annuities don’t understand the tax ins and outs and often are told variable annuities are “safe.”
 
8.      Variable annuities typically lack liquidity and can tie consumer money down with prolonged surrender penalty periods. If you need to get your money out for a pressing need, too bad.
 
9.      Variable annuities convert lower capital gains rates on taxable income (if the annuity is purchased with after-tax dollars) into a higher tax rate levied on ordinary income. This can cost consumers significant tax dollars down the road.
 
Forbes cites a study by Richard Toolson, an accounting professor at Washington State University, who looked at break-even points for variable annuities versus investing the same money in a lower-turnover stock index mutual fund. He assumed both earn the same pre-tax return. According to his calculations, an individual in a 36% tax bracket will never come out ahead by investing in a variable annuity due to the prolonged drag of fees and tax issues.
 
There are unusual situations when a variable annuity may make sense (e.g., doctors who are concerned about malpractice suits). Three-quarters of states protect variable annuity assets from creditors. Regular individual retirement accounts do not benefit from federal protection and may be more vulnerable to creditors. There are a few other instances when variable annuities may make sense, but they’re few and far between. More often than not, it’s clear that variable annuities always benefit the seller, and only infrequently benefit the buyer.
 
If a new client comes to me with variable annuities, I have an annuity expert who reviews them and provides objective feedback. If the annuity is in an individual retirement account, it may make sense to dismantle the annuity altogether. If the annuity is funded with after-tax money (a so-called “non-qualified annuity”), it can be rolled into a less expensive annuity via a  “section 1035 exchange.” The annuity can’t otherwise be terminated if funded with after-tax dollars.
 
To quote financial commentator Suze Orman: “I hate variable annuities with a passion…especially variable annuities that are used in retirement accounts…I think variable annuities were created…for one reason only…to make the financial adviser selling you those variable annuities money.” Well said.
 
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Eve Kaplan, CFP, is a fee-only advisor in Berkeley Heights, N.J. with 27-plus years of professional investment experience. Kaplan Financial Advisors is a Registered Investment Advisor in New Jersey and New York. 
She can be reached at www.kaplanfinancialadvisors.com or 908-898-0549.

 
She has written about variable annuities in previous years and sometimes holds “Annuities: Pros and Cons” workshops in Central New Jersey.
 

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