Variable annuities are the Total Gym of investments. They promise a quick, easy, all-in-one solution wrapped in an irresistible sales pitch. Fun and easy weight loss in 6 to 8 minutes per day! If it’s good enough for Chuck Norris and Christie Brinkley…
In the end, you’re out a thousand bucks, you still need to lose 10 pounds and the only thing the Total Gym does is sit around collecting dust.
Over the years, I’ve met with lots of people who needed help figuring out what to do the variable annuities they’d purchased in the past. In almost every case, these investment products have failed to live up to the original sales pitch.
I’m sick of dealing with these things, so today I want to give you five reasons you should avoid variable annuities for retirement.
Note: If you own a variable annuity (or a Total Gym), please don’t feel ashamed. Millions of people have purchased these confusing but wonderful sounding products, so you’re in good company. Stay tuned for my next post on the four ways you can get out of a variable annuity.
Why Use Variable Annuities for Retirement?
Simply put, an annuity is an insurance product that turns a lump sum of money into a cash flow stream. That cash flow stream may start immediately (an immediate annuity) or sometime in the future (a deferred annuity).
It’s essentially a pension that you can buy. Sounds like a good idea, right?
Immediate annuities are pretty straightforward and work a lot like life insurance. You get payments for life based on the amount you invest and your life expectancy. The payments can be higher or lower based upon the details of the policy.
If you live past your life expectancy, then you get the better end of the deal. If not… well… at least you’re not around to stress about it. As it turns out, life insurance companies are really good at these calculations. They’ve been at this game for a long, long time.
Deferred annuities complicate things a bit. What you pay into the policy is invested by the insurance company until the time you decide to exchange those investments for a guaranteed income stream. This is known as the moment you “annuitize” the investment.
Annuity Investments: The Plot Thickens
Once upon a time, when deferred annuities started out, their investments grew at a rate that was guaranteed by the insurance company. Basically, the guaranteed growth rate of the investments was the minimum they thought they could realistically achieve.
Since these guaranteed rates tended to be pretty low, someone came up with a bright idea. “Why don’t we allow annuity customers to invest in the stock market? We could tie the growth rate to, say, the S&P 500.” These creations were called indexed annuities; their investments were tied to a stock market index.
Indexed annuities flew off the shelves and, lo, the insurance companies rejoiced.
Quick, Think Of Something Else To Sell
Because of the popularity of indexed annuities, the next logical step was to figure out how to let annuity customers invest in the new-fangled mutual funds that were all the rage.
Securities and insurance laws didn’t allow for the actual mutual fund shares to be purchased in the policies, so they created things called “sub accounts” that walked, talked and quacked just like mutual funds.
In fact, most insurance companies outsourced the management of their sub accounts to popular mutual fund companies. This way, they could charge extra and capitalize on the brand names of the fund managers. Sweet.
And thus, the variable annuity was born.
So we arrive at the present day where variable annuities have a plethora of mutual-fund like investments to choose from. They promise to grow your pot of money until you decide to turn those investments into a lifetime income stream.
What’s not to like about getting income payments for life? Why wouldn’t you buy a variable annuity? As it turns out, they often don’t have the fairytale ending you’d expect.
Here are five reasons to avoid buying a variable annuities for retirement.
1. When You Buy A Variable Annuity, You’re Stuck
Almost all variable annuities have surrender charges – fees you must pay if you withdraw your money from the policy. These fees start off prohibitively high during year-one and gradually taper off over time.
How high are the fees and how long do they apply? Surrender charges can be as high as 10% ($50,000 on a $500,000 investment!) and take as long as 10 years before they go away.
Ten years is a long time to be stuck in a bad relationship.
Why are surrender fees so darn high? It’s because most annuity products pay a handsome commission to the salesperson when he or she sells you the product. These commissions can range between 4% and 7% of the annuity value.
If you decided to withdraw your money in year-one, then the insurance company takes a big loss on the commission paid to the agent. Hence the surrender charges that keep you locked in.
And just to rub salt into the wound, you are not allowed to use a 1035 Exchange to move from an annuity to a life insurance policy – even though you can move the other direction. At best, you can use a 1035 Exchange to move from one annuity to a slightly less annoying one.
Talk about ‘til death do us part. Getting divorced might be cheaper and easier.
If you own a variable annuity and want out, stay tuned for my upcoming post about the four ways you can get out of a variable annuity.
2. The Fees Are Astronomical
Variable annuities are chocked to the gills with fees. Let’s have a gander, shall we?
- Mortality and expense (M&E). This is the cost of the insurance component of the annuity and can range from 0.50% to 1.50% per year.
- Administrative expenses. These fees, between 0.10% and 0.30% per year, pay for ongoing service, account fees and general administrative costs. Someone has to pay for all those commercials with whales leaping out of the ocean.
- Underlying investment expenses. Think of these like you would think of mutual fund expense ratios. Each investment in the contract will have associated costs that can run from 0.25% to 2.00% or higher.
- Costs of annuity riders. If you’ve added any riders to your policy, such as a guaranteed death benefit rider, those expenses can run between 0.25% and 1.00%
All in, you can expect to pay between 2% and 4% per year in fees. For a $500,000 variable annuity, that equates to $10,000 to $20,000 per year. This does not include any potential surrender fees you’d incur if you decided to take your ball and go home.
In my opinion, variable annuities for retirement don’t deliver enough value given how expensive they are. For a fraction of the cost, you can hire a fee-only financial advisor to manage your investments, create a comprehensive financial plan and actually talk to you on a regular basis.
3. Guarantees Cost Extra
Guarantees are a big selling point for annuities. Unfortunately, almost all of the guarantees available in these products are à la carte – and, of course, cost extra. There are only a few guarantees that comes with all variable annuities.
- Once you annuitize the contract and start receiving a series of regular payments, those payments are guaranteed by the insurance company.
- A death benefit is provided to your heirs. The amount is the sum of the total premiums you’ve paid. As it turns out, this guarantee is a bit of a slight-of-hand. The death benefit is essentially a life insurance policy paid for by a portion of your premiums.
- Most variable annuities will guarantee something called the “benefit base”. This is essentially a minimum amount that you can annuitize, even if your annuity investments have tanked. But you best believe that your premiums pay for this feature too.
Everything else needs a rider and costs extra. Get ready for that up-sell pitch!
4. They Are Confusing As Hell
Have you been able to read this far without your mind wandering? With everything going on in these complex products, it’s hard enough to simply judge whether these are good investments or not.
Variable annuities are subject to similar withdrawal rules as IRAs and 401(k) plans, including a 10% penalty for early withdrawals before age 59-1/2. Don’t forget that annuity tax rules aren’t straightforward, either.
As I mentioned before, the costs are so high that your investments need to perform well just to break even every year. And there’s a non-zero probability that the person selling you the annuity doesn’t fully understand the policy.
Like the Total Gym, variable annuities are the investments that try to be all things to all people. When does that ever work?
5. Tax Advantages Don’t Apply To Annuities Inside IRAs
Variable annuities have some of the same tax advantages as certain retirement accounts, such as IRAs. Specifically, your investment growth is tax-free until you start withdrawing it.
However, investors miss out on this benefit when they purchase an annuity inside an IRA, 401(k), 403(b) or any other tax deferred retirement account. You can’t double-dip on tax deferral. It’s the investing version of wearing a belt and suspenders at the same time.
This is where annuity salespeople will counter, “Guaranteed income!” Sure, but as I mentioned earlier, those guarantees come at quite a cost to whomever buys the annuity.
There Are Simpler, Better Ways
The only reason annuity guarantees exist is because you pay for them. With a little discipline, a reasonable investment strategy and a dynamic retirement withdrawal plan, you can create your own lifetime income stream using cheaper and more flexible investments. Simply put, there are better options than variable annuities for retirement.
For most retirees, the promise of guaranteed returns and limited downside risk ends up falling short in real life. A few years into the policy, the annuity owners notice that returns have lagged the market and they don’t hear from their salesperson anymore.
Just like the Total Gym, variable annuities fail to deliver on their promises.
Please don’t feel ashamed if you’ve bought a variable annuity. These are confusing products with a beguiling sales pitch; millions of people have purchased them over the years. Stay tuned for my post on the four ways to get out of a variable annuity contract.
If you still need help figuring out if an annuity is right for you, click here to set up a quick, complementary introduction call to see if Prana Wealth is a good fit. We are currently taking on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S.
We’ve helped plenty of clients avoid the variable annuity trap in the past and we’re ready to help you whenever you need it.