As a result of two major market panics in the last two decades, the use of variable annuities as a solution to the financial needs of the consumer has increased. These products have been marketed and re-marketed in various different formats with numerous bells and whistles. In some cases a variable annuity may make a great deal of sense. Many individuals who are young enough and in a higher income range may have already maximized their employer-driven tax shelters. With enough time on their side until retirement, the tax shelter of a variable annuity may provide substantial benefits. There are in fact a number of circumstances where such a long-term tax shelter may be advantageous. Tax sheltering dollars is the key to a deferred annuity. However, all too often variable annuities are marketed towards individual investors as a solution for 401ks and/or IRA’s because of the additional living benefits they offer, but those accounts are already tax-sheltered. So what is a living benefit really and do you need one?
What is a living benefit?
A living benefit is an insurance benefit that is connected to the account value of your funds. Historically, variable annuities offered a death benefit that would insure at least a portion of the value of your account for your heirs at death. Living benefits developed to offer coverage that can be applied in various ways. One way is the insurance of an income stream. For example: the insurance company may guarantee you a withdrawal rate on the funds in your IRA for the duration of your life. The percentage withdrawal rate would typically be based on the age at which you begin to draw a cash flow. So a 62 year old with $100,000 in an IRA who wished to supplement his or her income stream from that account could buy a variable annuity with a guaranteed withdrawal rate of 4% annually for the duration of his or her life, or $4,000 per year. Even if the portfolio were to decline to zero at some point in the future, the insurance company will continue to pay this 4% cash flow. While this might sound great to some…let’s take a closer look.
The first thing to look at is the 4% cash flow. The 4% in a guaranteed withdrawal benefit is typically NOT a guaranteed rate of return. It is simply the maximum amount of your own money that you are permitted to withdraw annually. The rate of return is dictated by the underlying investments which can go higher or lower on any given day, no different than any investment account. Since the insurance company is on the hook for the cash flow should your investments decline to zero, they typically put some constraints on the investment flexibility within the contract. They may for example mandate an allocation that has at least 70% stock-market exposure. Various studies in the financial planning field have taught us that someone who maintains an asset allocation of 60% equities and 40% in fixed income and draws 4% of their assets proportionately each year has an excellent chance of stretching their portfolio at least 30 years. For that same 62 year old, that brings you to age 92…past your statistical life expectancy. So as we can see, the insurance company is simply limiting your cash flow for you, and it is highly unlikely that they will ever have to pay you from their own funds.
Mortality & Expense Fees
Expenses are another major issue to consider when examining a variable annuity with living benefits. Every contract has what is a called a Mortality and Expense Fee (M&E Fee) which has to be paid each year. The average M&E fee is around 1.25% of the value of the contract although it can range as high as 2%. This is a separate and distinctly different fee than the mutual fund expenses that will also come out of your account. The first thing to note is that had you built your portfolio outside of the annuity contract with the exact same investments, you would have rate of return in excess of the annuity product offered by exactly the amount of the M&E fee. So if the contract guaranteed you the ability to draw 4% annually from your own account, which is highly probable anyway…the cost to get that 4% guarantee is that you must pay the insurance company 1.25% per year.
Another important component is what value the M&E fee is accessed upon. If your contract started at 100k, but then declined to 80k after several years of making withdrawals…the 1.25% may still be based upon the original investment. Some annuity contracts have been written in such a way that the M&E is based on either the original investment or any increase in value to the investments. However, if your account goes down due to a market decline, withdrawals or some combination thereof, you might be stuck paying 1.25% of 100k even though your account is only worth 80k. This makes many of these contracts much less attractive and substantially more expensive upon a closer look.
Fund expenses are another factor to consider. Once again are separate and distinctly differently than the M&E fees. While many investors wish to use mutual funds as a way to diversify a portfolio, they should pay close attention to the fees charged by various funds. Mutual funds in a retail account are sold in shares, while mutual funds in an annuity contract are sold in units. It is quite possible to have the same style fund with the same fund manager but see an entirely different expense ratio. In many cases, the fund offerings available in a variable annuity have substantially higher fees than what you would pay to buy the same fund or something similar in a regular retail investment account. More often than not, the annuity version is more costly by 1% or more.
Surrender charges are another substantial consideration. Because these contracts are designed to offer these benefits by pooling risk, they need to guarantee control of your assets for a period of time. So they commonly apply surrender periods that can mean you are prevented from closing or transferring your account for 5-7 years without paying a penalty. Depending on the contract, the surrender fee can be a substantial portion of your account value.
The term “annuity” refers to many different types of products. Some of them offer valuable benefits when applied properly in the right circumstances. Some companies offer some very low-cost versions of these contracts. However, investors should look very closely at the fine print before committing to any contract. In the case of living-benefit variable annuities, you could end up paying 3% or more of the account value in fees just to obtain a guaranteed cash flow of 4% to 5%. The word “guarantee” can sound very attractive to many investors, bet in the case of living benefits…more often than not, the guarantee isn’t really worth the cost.