Variable Annuities – Have You Looked “Under the Hood”?

6a017c332c5ecb970b01a5116fb332970c-320wiInvestors often purchase annuities without really understanding what they bought, usually because the sometimes over-hyped guarantees sound so good their eyes tend to glaze over.

Variable annuities differ from fixed annuities in that assets are invested in mutual funds.

Think of a Reese’s cup.  Peanut butter inside are the mutual funds; the chocolate coating is the insurance wrapper… which brings up the point:  There are some differences from investing in mutual funds directly:

  • Investments grow tax deferred – the insurance wrapper buys tax-deferral
  • There is a death benefit which typically protects what you’ve put in
  • You can elect periodic payments for the rest of your life at retirement – or the life of your spouse, which helps protect against longevity risk.

I won’t go into the nuts and bolts here; the SEC offers an excellent overview of variable annuities and you can access it here.

But, here are a few things you should know.

While variable annuities do allow assets to grow tax-deferred, that deferral feature comes at a price – and it can be a rather stiff one.   That insurance wrapper, according to the SEC, can typically be around 1.25%… and this is in addition to the mutual fund charges, some of which are well-hidden.  You can learn more about what you need to know about mutual funds here.

There are also administrative fees.  While these fees can be small, they should be flat fees, not percentage fees;  after all, if it costs $X to process a transaction, why should the cost of processing increase just because your account balance increased?

There are also add-on charges for any riders you elect.  When added to the underlying fund expenses, it can look something like this:

Typical Annual Fees for Variable Annuities:

Mortality and Expense Risk (insurance wrapper) 1.25%1
Administrative Fees 0.15%2
Optional Guaranteed Minimum Death Benefit Rider 0.61%2
Optional Guaranteed Lifetime Withdrawal Benefit Rider 1.03%2
Fund Expenses for Underlying Funds in Variable Annuity 0.94%2
Total Cost 3.98%

1Securites and Exchange commission, Variable Annuities: What you should know.

2Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38, 56.

However, as I mentioned, mutual funds have additional hidden expenses beyond the quoted annual expense ratio we’re all familiar with.    When you factor those in – and our report will explain how you can come up with a reasonable estimate for yours – you’ll see something pretty clearly:  It may take a lot of years of tax deferral to “buy back” all the costs you’ve accumulated in your variable annuity.

Nevertheless, variable annuities can be worthwhile for the right investor who is already maxing-out more traditional retirement options, i.e., 401(k)s, IRAs, etc.  They key, of course, is to buy smart.

If your advisor is a Registered Investment Advisor, chances are good s/he can help you select a quality no-load3 variable annuity that uses low-cost funds and has fixed-dollar admin fees.

Remember, no one can control the markets; but we can try to control costs and taxes.

Jim

3Surrender charges generally occur when a company has to recoup commissions advanced to the salesperson.  No-load generally means no commissions and therefore no surrender charges.

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RESOURCES:

IFG Report:  The Hidden Risk No One Talks About (registration required)

A Financial Conversation Checklist (does not require registration)

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742. IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.

The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.