The brave new world of variable annuities
Variable annuities have had such a bad rap in some financial planning circles that many advisors refuse to discuss them—let alone recommend them for clients. It’s no wonder, because the negative image of variable annuities looks something like this:
Picture a well-intentioned middle-age couple—risk-averse and nervous about saving enough for retirement—who stretch their budget to purchase a high-cost variable annuity with all the bells-and-whistles from a pushy insurance salesman who is paid on commission and has no fiduciary obligation to consider their best interest. Their hard-earned savings become locked up in an inflexible product that eats away at their principle through asset-based fees charged for complex insurance riders that they don’t understand. Eventually, they end up paying a surrender charge that could be as high as 7 percent to exit the policy and regain access to their assets.
Indeed, in our experience as financial advisors, we have seen more than one new client arrive burdened by a high-cost variable annuity that is poorly suited to their personal situation or financial status. It’s no surprise that many consumer advocates have questioned the value of variable annuities and the tactics used to sell them.
But here’s what many investors and their advisors may find surprising: Variable annuities have changed. In fact, more independent Registered Investment Advisors (RIAs) and fee-based financial advisors are recommending this new breed of variable annuities to investors. Here are two big reasons why:
Variable annuities can provide tax-shielding benefits, similar to qualified plans such as 401(k)s and IRAs. That’s especially useful for aggressive savers and high net worth investors who are able to max out contribution limits in a given year. This new breed of low-cost, no-load variable annuities is designed specifically for tax-deferred investing, offering more fund choices, greater transparency and stripping away complex and costly insurance components that investors—and even many advisors—find hard to comprehend.
Still, the subject of variable annuities can get a bit heated. We think a good place to start the conversation is by addressing five common complaints—and what’s changed so that we can confidently recommend VAs that are in our clients’ best interest.
1. Variable annuities are primarily used for the insurance.
In the midst of a “features and benefits arms race” that has gone on for decades, most variable annuities today are sold with additional insurance riders such as income guarantees and enriched death benefits.
But variable annuities were originally designed as a vehicle for tax-deferred savings accumulation. They take advantage of tax code provisions that permit deferred taxation on earnings generated “inside” the product. And this is exactly the focus of a new breed of VAs. Their purpose is not about the insurance—it’s about creating a simple and efficient vehicle for saving money tax-deferred. Research shows that by keeping costs low and eliminating excessive asset-based insurance fees, clients can maximize the benefits of tax deferral to accumulate more for retirement and to generate more retirement income.
And investors do have more cost-effective choices than the insurance riders sold with traditional VAs. To protect against downside risk, now some VAs offer a much broader selection of funds allowing investors to more accurately match their tolerance for volatility, investment goals and time horizons. To provide a death benefit, many investors can purchase a simple term life policy.
And, while most variable annuities today are still sold by an insurance agent or broker who earns a commission every time they put a client into another new annuity, this new breed of low-cost, no-load VAs are typically recommended by RIAs and other independent fee-only financial advisors who make a fiduciary commitment to their clients.
2. Variable annuities are too expensive.
Many variable annuities continue to be expensive—especially those sold with up-front fees for commissioned sales reps, plus insurance company fees charged as a percent of the assets invested, plus the cost of the investment options inside the VA. The insurance fees alone can range from an average of 1.35% for the basic mortality and expense fees, to as much as 4% per year when various income guarantees are included.
But variable annuities don’t need to be expensive. With this new breed of low-cost VAs, structured solely as a vehicle for tax-deferred savings, investors pay only a modest insurance fee for a tax-deferred wrapper. This insurance fee is typically one-half to one-third the industry average. There is even a flat-fee VA that charges just $240 per year, no matter how much you invest. This new breed of VAs also helps investors save more by stripping away the up-front sales fees that would be paid to a commissioned insurance agent. Vanguard, TIAA-CREF, Jefferson National, and others offer these low-cost, no-load products.
3. Variable annuities place strict limits on an investor’s choice of funds.
Most “traditional broker-sold” variable annuities offer a limited selection of funds—less than 40 on average. Instead of offering a broad range of choices from independent third party managers, many traditional VAs are likely to offer their own proprietary funds. And when that traditional VA includes an income guarantee, the selection of funds ratchets down even further.
But this new type of variable annuities designed for tax-deferred investing offer a broad selection of funds—small, mid, and large-cap equities, fixed income, non-correlated assets and alternative strategies—all the way up to 380 different tax-deferred funds from one VA, at last count. The choice of fund families can include household names, such as Fidelity, T. Rowe Price, Janus and PIMCO. Access to low-cost fund managers like Vanguard and Dimensional Fund Advisors offering passively managed institutional quality funds may also be available.
4. Variable annuities are tax-inefficient because earnings are eventually distributed as ordinary income.
It’s true that when earnings from variable annuities are eventually distributed, they are taxed as ordinary income—but that doesn’t make VAs tax-inefficient. Indeed, taxable gains on the sale of a mutual fund are deferred within a VA until withdrawal. The benefit that comes from years, even decades, of tax-deferred compounding can help to mitigate the impact of paying future tax bills. And in many cases, investors are in a lower tax bracket during retirement when they begin making their withdrawals.
Also consider that many types of assets are unfriendly, even downright ugly, when it comes to paying taxes. Coupon payments to bond holders, for example, are taxed as ordinary income. Actively managed mutual funds are required to annually distribute capital gains. By locating bonds and other tax-inefficient assets within the tax-deferred wrapper of a low-cost, no-load variable annuity, investors can engage in tax-efficient “asset location” in addition to “asset allocation”:
Locate “tax-ugly” assets such as most bonds, commodities and any actively managed or alternative strategy funds in tax-deferred qualified plans or variable annuities.
Locate “tax-friendly” assets such as passively managed equity funds, which are taxed at the lower long-term capital gains rates, in taxable accounts.
5. Variable annuities lock up your assets and are costly if you need to withdraw funds early.
The fact is that most variable annuities are sold on commission—and that means they also include a steep surrender charge that can lock up your assets for 5 to 7 years, or more. The good news is once these surrender charges have expired the expensive commission-based VA contracts can be exchanged to a new, low-cost, no-load VA contract through a “tax-free 1035 exchange.” However, consumers should consult with an unbiased expert such as an independent fee-only financial advisor, CPA or tax consultant to assist in the transition and avoid an untimely taxable event.
The new type of variable annuities does not impose a surrender period or surrender charges of any kind. Now it’s possible for investors to save more tax-deferred with these variable annuities and still maintain access to their assets. As with qualified plans such as 401(k)s and IRAs, investors may face a tax penalty for distribution before age 59 ½, so be sure to work closely with your advisor to determine realistic liquidity needs before investing in a tax-deferred VA .
While there are still many reasons to exercise caution when it comes to broker-sold conventional variable annuities, it’s clear that the new breed of low-cost, no-load VAs is well worth another look for many investors—especially the 77 million baby boomers who by many measures have not saved nearly enough for retirement. By helping to maximize the power of tax-deferral with lower cost, no commissions and a broader selection of tax-deferred funds, variable annuities can help investors build a nest egg more quickly, generate more retirement income, and potentially leave a larger legacy for their heirs.