by Tyler Conley, MBA, CFP®, CEPA®, Financial Planner |
August 9, 2020
Simply stated, variable annuities are not always bad, yet it is a unique circumstance when they are truly the best option for the client. The situations in which they meet the fiduciary standards (clients’ best interest) mandated by the CFP® board, are few and far between. I will outline how a variable annuity works, the costs associated with these annuities, the payout process, and pitfalls of why, in most cases, there are better suited investments/processes out there to accomplish the same end goal.
What is the definition of a variable annuity? A variable annuity is a tax-deferred retirement investment that allows an investor to choose from a selection of investments offered by an insurance company. The investment then pays the investor a level of income when annuitized that is determined based on the performance of the underlying investments which were selected by the investor. This investment vehicle differs from its better-known cousin, the fixed annuity, which provides a guaranteed payout.
Variable annuities can have high hidden fees fluctuating from 2% to 4% annually. These high fees combined with your future withdrawals can quickly erode the cash value associated with the policy. From an estate planning aspect, this can result in leaving nothing for your policy’s beneficiaries. Additionally, these high fees really hamper an investor’s overall investment performance.
Variable annuities commonly have up to five different fees. An investor can add à la carte guarantees/riders to their policy to customize it. However, each guarantee and/or rider that is added to a policy comes at an expense (generally a high one at that!).
A policyholder has the right to call their variable annuity customer service line to ask what their policy’s specific fees are, which could include:
Fee #1: Mortality and Expense (M&E) Fee
Fee #2: Administration or Distribution Charge
Fee#3: Mutual Fund Manager Expense (averages about 1%)
Fee #4: Income Rider Fee, if applicable
Fee#5: Death Benefit Rider Fee, if applicable
Another hidden fee that is rarely discussed when a variable annuity is processed is the commission paid to the financial professional and the surrender period (explained later). Most variable annuities are still sold in the broker dealer world, which means the financial professional receives an upfront commission when a client purchases the variable annuity. The insurance company doesn’t want to be left having to pay this large commission to the advisor if the client pulls the money out too soon. So, they implement what the industry calls a “surrender period.” The surrender periods vary depending on how aggressive or large of an upfront commission the financial professionals decide to take. The surrender period is the amount of time an investor must usually wait until he or she can withdraw funds from an annuity without facing a penalty.
Many of these surrender periods for variable annuities can last from 5 to 7 years. A great deal can change in 5-7 years, which makes it a huge disadvantage to be stuck in an investment for that time period. Fortunately, the industry is starting to evolve very slowly with a select few insurance companies who now offer non-commission, fee-only offerings.
Even after a person has surpassed the surrender period, there is a difference between the payout balance and the cash balance associated with the contract. Many financial professionals will say that an investor will get a 5% guaranteed growth with an annual high-water-mark ratchet to lock in a new balance amount on their variable annuities. Wow! This sounds too good to be true...well, that is because it is!
This guaranteed growth and high-water-mark upgrade is tied to the payout balance, not a person’s cash balance. Depending on market conditions, the cash balance and the payout balance could be very similar. However, don’t let this fool you on exactly what the differences are or how these two balance numbers apply to you. The cash balance is your walk away from the investment amount. There might be some miscellaneous fees associated with exiting the policy, but in general, this is your “cash” or transferrable investment balance. In comparison, the payout balance is the “guaranteed growth” hypothetical pot of money from which you can eventually take withdrawals.
The insurance company is counting on you to either move the funds to another investment and/or not live long enough to utilize this full balance. Again, the insurance company will always pay back the investors’ money first until fully exhausting the accumulated balance before ever using any of their own funds.
Another less than pleasant feature of an annuity occurs if an investor needs to do a one-time withdrawal from the annuity prior to actually annuitizing the investment. Variable annuities and their earnings are tax deferred until an investor either annuitizes the contract or makes a withdrawal. If an investor withdraws money from the annuity on an individual basis rather than via a lifetime income stream, early payouts are considered taxable income on a first in last out basis. In other words, the payouts are taxed at the investor’s ordinary income tax rate, not the lower capital gains rate. Once the gains associated with the annuity have been exhausted, any future withdrawals would not be taxed and be considered a return of principal.
Another attractive sales pitch you might hear when purchasing a variable annuity might be the death benefit. You can lock in a death benefit for your desired beneficiaries while still getting an income stream from the annuity. Many annuity owners are under the impression that their family members will always receive the death benefit as a lump sum, but unfortunately that often isn’t true.
There is a big difference between the cash balance and the payout balance. An investor’s cash balance can and most likely will be significantly depleted upon annuitization as it is being eroded by both withdrawal amounts and the annuity fees. Many variable annuities will offer riders which guarantee payouts of 4%-5% for the life of the investor. When you take these annuity payments combined with annuity fees of up to 4%, the combined impact will result in a significant pull down on the investment’s cash balance.
Hypothetically, in a good market, the underlying selected investments can counteract the combined fees/withdrawal; however, consider the devastation that can occur in a down market. By withdrawing 8%-9% per year from the investment at some point during the investor’s lifetime, the cash balance will most likely run out of money. If the cash balance runs out of money, the insurance company turns on the guaranteed income rider to keep making the obligated lifetime income payments until the death of the investor.
Turning on the guaranteed income rider comes at the cost of the investor’s family as they will no longer receive a lump-sum death benefit. From the insurance company’s perspective, this makes sense and is also mentioned in the fine print of the investment. The insurance company can’t afford to give the investor both their stated lifetime income per year and pay back the entire death benefit to the beneficiaries if there is no money left in the account.
Some brokers have told their clients to cease taking the yearly income when the cash balance reaches $1,000 in order to preserve the lump sum death benefit for their beneficiaries. The flaw with this proposed idea is that the associated fees on the policy may still result in depleting the full cash balance. This is due to the insurance company charging their rider fees based upon the income rider value and/or the death benefit rider value, not the cash balance value.
These rider values will still have a very high dollar value despite what the cash balance is. In addition, most investors will have become accustomed to receiving this annuity payment in their lifestyle expenses, so ceasing to receive it could be problematic for cash flows.
A certain investor, given the perfect scenario, might benefit from a variable annuity as a possible investment tool to achieve their goals. However, by investing in a dynamic well-diversified portfolio, utilizing a cash flow management strategy, investors can achieve the same outcomes without any of the above-mentioned hurdles/restraints. These same outcomes can be produced without surrender periods and multiple fees, but with improved transparency, reduced expenses, broader investment options, improved flexibility, and tax-efficient withdrawals. Furthermore, these diversified portfolios can be set up to distribute the systematic payouts similar to variable annuities.
In summary, the next time you are thinking about purchasing or considering what to do with a previously acquired variable annuity, consult a Syverson Strege planner at 515-225-6000. They will be able to evaluate the annuity to see if it’s an applicable fit. Remember, all planners at Syverson Strege are CERTIFIED FINANCIAL PLANNERTM practitioners and fiduciaries. Therefore, your best interest is their first priority all the time!
Tyler (TC) Conley grew up in Ankeny, Iowa, and is a second-generation CERTIFIED FINANCIAL PLANNER™ practitioner in the Des Moines community. He joined the team at Syverson Strege in 2019 as a CERTIFIED FINANCIAL PLANNER™ practitioner. He also holds Certified Exit Planning Advisor (CEPA®) and Certified Divorce Financial Analyst (CDFA®) designations. In his role at Syverson Strege, Tyler puts an emphasis on developing strong relationships with clients through the comprehensive financial planning process which helps provide clarity and understanding on clients’ pathways to financial success.