YOUR FINANCIAL FUTURE / SO WHY DO YOU OWN A VARIABLE ANNUITY?

“So, I see that as part of your portfolio, that you own a variable annuity”, I say. “Why did you acquire it?” “What are the benefits of the annuity?” “Are you aware of how the funds are invested?” “Are you aware of the investment performance?” “How about the riders; do you know what they are, what they cost and what benefit they provide?” “And, how about the fee structure of the investment accounts?” “Are you aware there is a surrender charge if you withdraw more than 10% annually?” These are some the questions I have recently posed. And, I am sure you won’t be surprised to learn that each of my new or prospective clients could rarely answer more than two of these questions.

Annuities are simple in concept, complex in reality. You give an insurer a sum of money, or in the case of an employee working for a not-for-profit institution like a school or a hospital, your contributions to an annuity are deducted from your paycheck. The funds are invested in a managed pool of assets called subaccounts.

The annuity contract allows your funds to grow on a tax-deferred basis until you start receiving income.

What do we find when we look at the details?

  • The fees are usually high, anywhere from 2% to over 3% annually. First you have a mortality and expense charge which covers the cost of the insurance, administration and the seller’s commission. In addition you have the investment management fee for the subaccounts. All in all, the expenses are double or more than many taxable mutual funds.
  • The subaccount investment options within a contract may be limited.
  • While many contracts allow you to take 10% withdrawal annually, should you need more, you will pay a surrender charge. While the charge declines over time, it can go on for up to eleven years. This is to reimburse the salesperson’s commission, which by the way can be anywhere from 4% to 8% of the investment amount. Yes, a $250,000 investment in an annuity means you have paid a commission of $10,000 to $20,000.
  • What about that rider called a “guaranteed lifetime withdrawal benefit”, also known as a GLWB? There is often a misperception of what this benefit means. Retirees may believe that the cash value of their contract is guaranteed to grow

at a certain percentage, say 5% per year, “when in truth it’s simply their benefit base against which withdrawals may be taken – a deeper analysis reveals that in the end, most retirees with a GLWB rider may do little more than pay a lot in annuity costs to receive a guarantee to just spend their own capital contributions and nothing more.” *

  • Income distributions are taxed as ordinary income, not the lower taxed capital gains that could be achieved from a taxable investment. The difference can easily erase the advantage of the tax-deferred compounding within an annuity.
  • Annuities are not advantageous to inherit if the proceeds do not go to a spouse. If the annuity was purchased with after-tax money, the heirs will not receive a step-up in basis of the investment gains. This is a clear tax disadvantage versus a taxable investment.

When a client comes to me with a variable annuity, I obtain independent feedback from an annuity expert. If the assets are in a tax-sheltered annuity or an IRA account, it may make sense to roll it over to an IRA without tax consequence. If it was acquired with after-tax funds, the funds have to remain in an annuity but it can be rolled-over to a less expensive annuity via a 1035 exchange, again without a tax consequence.

Variable annuities are complex contracts which many investors and perhaps even the sellers do not truly understand. The supposed tax benefits and guarantees are often overhyped while the fees, surrender charges, tax issues and complexity of the benefit riders is ill-explained.

Ladies and gentlemen, if you don’t understand it, don’t buy it.

Roxanne E. Fleszar, CFP, ChFC is President of Financial Resources Management Corp, a registered investment advisory firm with offices in Key West, Boston and Naples.

*Michael Kitces Blog, July 2, 2014 “Why It Rarely Pays to Wait on Taking Withdrawals From a Variable Annuity GLWB Rider-A Case Study”

as published in KONK LIFE on June 4, 2015

[livemarket market_name="KONK Life LiveMarket" limit=3 category=“” show_signup=0 show_more=0]