What’s a variable annuity?
If you’re unfamiliar with annuities — you give an insurance company your money and in return they pay you an income stream, usually for the rest of your life. The annuity company uses several factors to determine your payment amounts including life expectancy. In essence, you are betting against the insurance company that you will live longer than expected.
Variable annuities are commonly called “mutual funds with an insurance wrapper.” In an all-in-one package sold by an insurance company, a variable annuity combines the characteristics of a fixed annuity with the benefits of owning stock or bond funds. Investors pay a premium to the insurance company, which then buys accumulation units under the investor’s name.
Annuities are often sold on the premise of “safety”. They offer a return on investment and promise of principal protection. When markets are volatile people often gravitate toward products that use the words “guarantee” and “safety”. Before you purchase one of these products, we urge you to read this and consider the shortfalls of variable annuities.
- FEE’s, FEE’s, FEE’s
Annuities come with some of the highest fees of any investment vehicle available. Between management fees, administrative fees, and rider fees a variable annuity can have an average annual fee of 3%. That means that on a $500,000 annuity you will be paying $15,000 a year to the insurance company.
- They are complicated
I once reviewed the prospectus of an annuity for a client and was shocked to find out that it was 1,100 pages long! How could anybody understand what they are buying with a prospectus like that?
The truth is that most people don’t fully understand annuities including the people that sell them to you. Now, let me ask you a question. Do you think that the reason these products are made so complicated is to protect you? Probably not.
- Surrender Fees
That’s right, more fees! Let’s say that you buy a variable annuity and two years in you realize that you’ve made a mistake and would like to cash out. Well, most annuities come with a surrender charge and a lock up period of around 7 years. This means that at any point you would like to withdrawal funds from the annuity you will be hit with a hefty charge.
I have personally seen surrender charges as high as 8% which are used to protect the insurance company against the high commissions that they pay to their sales agents up front.
When someone sells you an annuity, they are usually paid a nice commission by the insurance company. Commissions on annuities can get as high as 10% per product sold. This pay structure can muddy the waters of an advisor/client relationship. Someone who is paid a commission on the products that they sell will rarely have their client’s BEST interest at heart. The higher the commission, the more difficult it is to sell with full disclosure and in an honest way.
- Illiquidity and estate planning
One of the main selling points of an annuity is its safety in guaranteed payments for life. While that sounds comforting you need to realize what you are giving up in return. Let’s say you have an unforeseen medical expense in retirement not fully covered by Medicare. Well, remember that if you are in that lock up period any money taken out will be hit with that surrender charge.
Annuities also give you less flexibility when it comes to estate planning. During the annuitization phase the highest form of payout for an annuity is called “single life”. This means that when you pass, your payments will end, which is not ideal if you are married. You could select “joint-life” which will pass your payments to your spouse, but this will decrease your payments.
Most annuities are tax deferred meaning that any money taken out will be taxed as ordinary income. Unlike other investments where gains are taxed at capital gains levels (0%, 10%,15%, 20%) any gains made in an annuity are taxed at the often-higher ordinary income level. This can be a nightmare for someone who wants out of an annuity but has a low-cost basis.
While annuities may make sense for some, we often advise clients to avoid them as we believe there are better options. We provide complimentary annuity reviews for anyone who asks. If you are currently invested in an annuity and would like to know your options, we would be happy to help. Call us at 610-825-3540 or you can schedule a call using our “speak to an advisor” button at the top of our website.