In recent years, variable annuities have been increasingly pitched by brokers and insurance agents as an important part of the retirement plan of many investors in the United States. In fact, many of the features heavily advertised by advisors are what persuaded thousands of Americans to invest in these products, especially senior citizens. However, once variable annuities are carefully analyzed, it is clear that many of the features that are heavily promoted are misleading. Investors can find themselves locked in an investment that produces little or no economic benefit.
Variable annuities are being pitched as “guaranteed investments” with great features, including the possibility of a “guaranteed lifetime withdrawal benefit.” In fact, approximately half of all financial advisors with Series 6 or Series 7 licenses and an insurance license are now recommending variable annuities for their clients.
A variable annuity is a contract where an insurance company guarantees a minimum payment to the investor. The timing on the payments will depend on the actual terms of the particular variable annuity purchased. The variable annuity prospectus lays out all the fundamentals of which investors should be aware. A fundamental feature of all variable annuities is the selection of funds or so-called “subaccounts.” These subaccounts are where the investor’s money will be invested. Other common denominators of all variable annuities are the commissions and fees that are built into the product’s design.
Sadly, variable annuities are some of the most fee-loaded investments out there. Investors need to be aware of these upfront commissions and on-going fees before they decide to invest in these products. Initial commissions for variable annuities vary, but they range between 2 and 6 percent. In addition, other added fees may diminish or extinguish any potential benefit that was pitched to the investor in the first place. Last year, the Securities and Exchange Commission posted on its website a section explaining some of these fees.
The SEC also offers other tips and information investors should consider before investing in a variable annuity. The SEC variable annuity article highlights some of the fees investors will be responsible for, including:
• Mortality and expense risk fee: This fee is based on a predetermined percentage of the investor’s account value, which usually ranges between 1 and 2 percent. This fee is set in place by the insurance company to offset the purported risks it assumes under the annuity contract. This fee is also usually deducted from any income percentage guaranteed to the investor.
• Surrender fees: If money is withdrawn within a certain period of time after a variable annuity purchase — for example, the surrender period — the insurance company will charge investors what’s known as a surrender fee. In most instances, the surrender fee is a percentage of the amount an investor decides to withdraw. Since the surrender period can last anywhere from 6 to 10 years or more, investors who can be greatly affected by surrender fees are senior citizens and investors who unexpectedly need access to their money.
• Administrative fees: This fee is designed to cover all administrative expenses, and it’s based on a percentage of the account value, which can vary greatly depending on the variable annuity purchased.
• Subaccounts fees and expenses: These fees are usually charged by mutual funds and other investment vehicles in which the annuity will be investing through the subaccounts. These costs are directly passed on from the insurance company to the variable annuity holder.
• Fees for other optional add-ons: There are extra fees charged by the insurance company associated with extra options like stepped-up death benefit, a guaranteed minimum income benefit, long-term care insurance, and others. These charges will vary greatly, depending on the specific options selected by the investor.
Investors should also be aware that annuities are taxed differently than other tax-deferred vehicles. Although it is true that by investing in a variable annuity all potential gains generated in the “subaccounts” go untaxed — unlike most regular mutual funds — all gains remain untaxed only while in the annuity.
But perhaps the most crucial factor about variable annuities is that all withdrawals are taxed as ordinary income, not as long-term capital gains. Long-term capital gains are taxed at 15 percent and ordinary income can be taxed as high as 35 percent depending on the investor’s income. In other words, all gains reflected from a variable annuity investment will be taxed up to 20 percent more than all gains reflected from a mutual fund investment or a 401(k) plan.
As mentioned above, many variable annuities are sold with what’s commonly known as a “guaranteed lifetime withdrawal benefit.” However, what many investors are unaware of is that the lifetime withdrawal benefit is subject to the fees described above. Consequently, when an investor is promised a pre-determined percentage guaranteed payment for life, all fees and expenses will be deducted from that pre-determined percentage before distribution. In other words, instead of receiving the misconceived pre-determined percentage, investors end up receiving a severely reduced percentage, which is not anticipated by investors upfront.
Investors should be mindful that there are other tax-deferred vehicles that may be more effective and more suitable for their needs. For example, depending on the investor’s current situation, electing to make the maximum allowable contributions to an IRA or 401(k) plan may be a more suitable option than purchasing a variable annuity. Before investors decide to invest in a variable annuity, they should be prepared to ask several due diligence questions of their insurance agent or financial professional about the above-described fees, commissions, and expenses and then determine whether a variable annuity is right for them.