At first glance, variable annuities list many benefits:
- Tax-deductions for qualified-annuity contributions
- Tax-deferred growth of investments
- Payouts for life and beyond
- Potential for diversified portfolio
- Borrowing of cash value
- Death benefit – usually the greater of a set amount and the contract’s cash value at the time of the owner’s death
On closer inspection, they are rarely appropriate. In the dark side of variable annuities, I described hidden fees, loads and other costs that can limit investment growth and penalize withdrawals. Moreover, other financial products provide the listed benefits, more efficiently. For example, term-life insurance provides a death benefit for a lot less money, and qualified retirement accounts offer tax benefits at lower cost. For investments outside of an IRA, annuities can provide a benefit for some clients depending on their risk tolerance and income tax levels. However, there is a way to do this without all the fees! Twenty years ago, I was surprised to see insurance agents and brokers sold variable annuities in IRAs. Now I know which firms almost always do (and which to avoid)!
Whether you are handling your finances on your own or you have a financial advisor, you must have a basic understanding of variable annuities. So, here’s some annuity straight talk!
Variable Annuities 101
A variable annuity is a contract between an insurance company and a person, known as the owner. The contract requires the owner to remit one or more premiums that are divided between income to the insurance company and investments on behalf of the owner. Those investments are mediated through “subaccounts” – really, just mutual fund accounts – that can invest in securities, commodities and indexes. The annuity provider usually offers a (limited) menu of subaccount choices. (That’s where the “variable” label comes from – your returns and annuity value vary with your investment performance.)
Costs and Fees
Every contribution made to an annuity is subjected to immediate fees, including:
- Death benefit – The owner is getting life insurance and must pay a mortality risk charge, usually in the vicinity of 1.25 percent annually.
- Contract administration – The provider has to cover its administrative costs (and make a profit), and may annually charge a flat fee or a percentage of account value. These costs are typically assessed as initial sales loads, commissions and transfer fees.
- Investment management – Each subaccount may charge for purchases, exchanges and redemptions, as well as a percentage of the Assets Under Management. These fees go to the mutual fund manager and are typically higher than what you’d pay to buy the same fund directly. The higher fee is due to another hidden cost, called revenue sharing, that goes to the insurance company.
- Extra features – These include guaranteed minimum income benefit, refunds due to the death of an owner before the annuity date, stepped-up death benefits and even long-term-care insurance. The fees can be significant, often 1 to 2 percent per year, in addition to the other fees. Remember, when you add all of these fees up, they can total 4 percent per year. Really. After that amount of fee, it’s hard to keep up!
- Interest – The good news is that you can borrow some of the cash value tax-free. The bad news is that you have to pay it back with interest. Rules vary regarding payback periods and loan limits, depending on the type of annuity. This is a key reason why it’s wise to discuss your options with a financial advisor who understands how annuities work. It’s essential you find one who isn’t compensated by commission (hint: Banks, brokerage firms and insurance companies, but also some independent “advisors,” like on radio talk shows). It’s important to find an advisor who is not paid more (from an upfront commission) to favor annuities over other, probably superior, investments.
A lot of investors wish they hadn’t bought a high-cost annuity. Unfortunately, in order to pay the high commissions to brokers, the insurance companies levy high surrender fees. Surrender fees apply when an owner ends the contract within a specified number of years. Think of it as a deferred sales charge. The annuity provider subtracts the surrender fee from the contract’s cash value as of the termination date. The owner receives whatever is left. Surrender fees can be substantial, especially on index annuities. Often, they start out at 15 or 20 percent and slowly decline over the surrender period, a set number of years, usually six, 10 or more. In some contracts, you can make small annual withdrawals – say 10 or 15 percent –without forking over a surrender fee. Surrender charges are never tax-deductible.
Now turning to the wolf-in-sheep’s-clothing department, annuity providers sometimes offer “bonus credits,” which are partial matching funds for contributions. For example, a 3 percent bonus credit on a $20,000 contribution causes the provider to kick in $600. However, this is no free lunch – the annuity provider will almost certainly hide extra costs that pay for this feature, including:
- Stretching out the surrender period
- Boosting the surrender fee
- Charging higher expenses and mortality risk costs
- Assessing a special bonus credit fee
Needless to say, it’s important to find out the exact net benefits or costs that bonus credits confer. Also, beware the provider who urges you to exchange your current annuity for one with bonus credits – annuity exchanges may be costly.
A friendly offer by your provider to exchange your current contract for a “better” one may, if accepted during the surrender period, trigger surrender charges. To be worthwhile, the exchange must ultimately be more valuable than the compounded loss of the surrender fees. Bear in mind that a new annuity has a new surrender period, so you are back to square one in that regard. Even more insidious, often, the exchange is just an opportunity for your broker to get a new commission!
One factor that helps providers promote exchanges is Section 1035 of the IRS tax code, which provides for tax-free exchanges. You can make the exchange without paying tax on the capital gains and income from your investments. If you are stuck in a high-fee annuity, you might be able to exchange it into a no-load annuity to substantially reduce fees.
All annuities provide for tax-free growth of your contributions until the money is distributed. Beyond that, annuities may qualify for additional tax breaks. You must pay taxes on distributions from your annuity on the cash value in excess of the cost basis, which is equal to the sum of all contributions on which the income tax has already been paid.
An annuity held in a qualified employer retirement account or an IRA is called, naturally, a qualified annuity.
Contributions to qualified annuities are tax-deductible, which is a good thing, however, this also means that the annuity has no cost basis and therefore all distributions are ordinary taxable income. (Roth accounts are different – your contributions aren’t deductible and create your cost basis).
If you withdraw money from your qualified annuity before age 59-½, you might be subject to a 10 percent early-distribution penalty from the IRS. You must begin taking minimum required distributions from a qualified annuity once you reach age 70-½ (except for Roth IRA annuities, which have no such requirement). You can borrow from your employer plan annuity (not from your IRA), but the interest rate, payback period and maximum amount are tightly regulated.
The bottom line regarding variable annuities is that they are often more expensive than they initially appear. For example, if you buy a qualified annuity, you are not benefitting from the contract’s tax-free growth, because you get that anyway from the retirement account. The risks of investments can mean a loss in value. Index annuities offer guarantees against losses but often severely cap return potential, locking up assets for 10 years!
Before purchasing an annuity, understand its fee structure, restrictions and tax consequences upfront. It’s smart to consult with a fee-only fiduciary financial advisor before entering into an annuity contract so you can go in with eyes wide open.
For more annuity straight talk, read this recent blog post: Why Variable Annuities Lead to Retirement Horror Stories.