Annuities, fixed indexed annuities I refer to as 3rd Generation Annuities, are almost always one of the core tools I recommend in my retirement planning arsenal when structuring a safe, conservative, guaranteed retirement plan for my clients. Unfortunately, many of my clients leave my office and research annuities on their own only to come to the conclusion that annuities are AWFUL investments.
Why? The Internet is loaded with articles from some very well known financial celebrities like Suze Orman, Jane Bryant Quinn, John Biggs and even/especially the AARP supporting that position. The problem with these folks is that they lump ALL ANNUITIES into one group. This is just plain wrong, misleading, and it’s causing millions of people who would otherwise benefit greatly from annuities to avoid them all together.
That said, I just came upon a very well written article on annuities written by financial advisor, Josh Mellberg. So well written, in fact, that I’ve decided to include it in this blog and give him full credit.
His article speaks specifically about variable annuities. I refer to variable annuities as 2nd Generation Annuities. Personally, I don’t like them either. Josh, however, is somewhat open to them as you will see in this article. He believes that they can be considered as an investment. That said, I don’t. Yes, it’s true! Suze Orman and I actually agree on something. As for Jane Bryant Quinn, John Biggs ad AARP, they are all on this band wagon too. They all hate variable annuities.
I will setup a link here to my previous article written about 1st, 2nd and 3rd Generation Annuities. That article is a great overview (if I do say so myself) of how these annuities evolved and who they differ. I firmly believe that annuities, especially 3rd Generation Annuities, should be an integral part of everyone’s retirement planning. 3rd Generation Annuities work like a pension. (In fact, many pension plans purchase these annuities for their retirees upon their retirement.) They are safe. They have minimal to no fees associated with them and, they can provide a guaranteed income for life and the life of a surviving spouse.
I hope that Josh’s article will provide you with some beneficial insights. As always, thank you for taking your time reading this article and please, leave your comments and pass the article on to your family, friends and co-workers.
It’s a good life!
Randall A. Luebke RMA, RFC
What is a Variable Annuity and Should I Consider It? – By Josh Mellberg
A variable annuity is invested in what are called sub accounts, which are similar to mutual funds but have extra insurance fees attached to them, so the value will go up and down with the market. Many financial experts do not recommend them, especially as part of a retirement portfolio.
In fact, Suze Orman lists them as #1 on her hate list, particularly when touted as part of a retirement account. Jane Bryant Quinn says that she’d like to take all variable annuities and smash them to smithereens. John Biggs from TIA-CREF says that it’s never suitable to buy a variable annuity. Even AARP has spoken out on the topic, discouraging its members from ever including a variable annuity in their considerations for retirement funding.
Capital Gains Problem with Variable Annuities:
Of the several problems that experts see with the variable annuity, the one that hits many consumers the hardest is the capital gains problem. When variable annuities became popular in the 1990s, capital gains were taxed differently than they are now.
Since you do not have to pay taxes on capital gains earned under the umbrella of a variable annuity–or money earned through interest in investments–until you take money out of the account, it can sound like a good deal. And it is – until you want to remove your money.
At that point, you will be required to remove the gains first. Since this is the part that is taxable, you will be paying taxes when you begin to rely on the funds for income. On top of that, you will be subject to taxation on that money at your ordinary income tax rate, instead of at the long-term capital gains tax rate. This is almost always a higher rate, so you’ll have to pay even more money to the government.
The bottom line is, you may pay more in taxes with variable annuities now than when they were popular in the 1990s.
Fees Problem with Variable Annuities:
There are potentially seven types of fees associated with a variable annuity, depending on the company and the particular fund. We will cover the most common. The first of these is an Administrative Fee. Every year, fees can be deducted from the account for record keeping, paperwork, and administrative costs. This may be charged as a flat account maintenance fee or, as a percentage of your account value. Typically, but not in all situations, this usually comes in around .25% to .50% each year. While this doesn’t sound like very much, it’s $2,500 on a $500,000 investment. Over time, that can add up.
Most sub-accounts which are similar to mutual funds held in variable annuities also carry a Mortality and Expense Fee. This fee guarantees that your heirs will be paid at least a certain amount if you pass away before taking money out of the fund, even if the fund’s current value is below that amount. So let’s say that you buy a mutual fund in a variable annuity for $500,000 and the value of the annuity at your death is only $300,000. Your heirs will still get $500,000 if you paid a Mortality and Expense Fee.
This fee is can pose several problems however. First of all, any gains that your heirs receive from a variable annuity are 100% taxable, even though most life insurance is tax-free. Secondly, the fee is equal to a certain percentage of your account value, typically in the range of 1-2% per year. For a fund with a value of $500,000, you’ll pay $5,000-$10,000 in annual fees.
A third common type of fee is the Mutual Fund Fee. Mutual fund expenses are made up of sales charges and fees. While they often sound low, typically between .25% – 4% annually, depending on the type of fund, they can add up quickly. These fees generate major income for the companies that hold mutual funds. In 2006 alone, Wall Street made over $80 billion in Mutual Fund Fees.
Finally, there are fees for bells and whistles also referred to as rider charges. These rider fees are usually attached to your account contract, and they can add up quickly.
In fact, all of these fees can add up. One gentleman purchased a $1 million variable annuity and found that, after 5 years, the value had shrunk to $800,000. Since a rider on the fund said that it had to increase by at least 5% a year, the value should have been $1.25 million. Upon further investigation, the gentleman found that the fund did in fact have that value, but he would have to die to access the full amount. His only other option was to annuitize it, or turn it into a pension. But if he did that, he would lose control of his money.
If that wasn’t bad enough, he also discovered that he was paying $32,667 annually in fees for the fund. It was advertised as only carrying $10,000 in fees, but that only covered the Admin Fees. Once all of the fees he was not aware of were added up, the gentleman discovered that he had paid over $160,000 in fees in the five years that he had that fund.
Is a Variable Annuity Ever an Appropriate Investment?
With all this discussion of the negative aspects of variable annuities, many people wonder why they exist at all. The truth is, in some situations, they can be a good investment. If you’re looking for aggressive growth and can find one with low fees, it might be a good option for you.