A variable annuity (VA) is a mutual fund-type account wrapped inside an insurance policy. According to one estimate, by 2005, VAs outstanding exceeded $1 trillion. The abundance of VA sales is not a result of the demand. Instead, it seems mostly the result of the efforts of commission-based salesmen. Let's examine three investment-related motivations for considering a VA.
Reason 1: Tax-Deferred Growth
Annuities allow for the tax-deferred growth of earnings. That "benefit" comes at a high price - the conversion of long-term capital gains into ordinary income. According to a 2005 working paper on VAs by Jeffrey R. Brown and James M. Poterba, "Even with a horizon of 40 years, under the [2003] new tax rates, variable annuities provide a higher net of tax return only if the expense differential is under 25 basis points." Yet, the authors estimated that the average VA has expenses of 1.65%.
And holding equities in a VA also causes the loss of the potential for a step-up in basis for the estate of the investor, the inability to harvest losses, the inability to donate appreciated shares to charity and the loss of the foreign tax credit. And should the buyer need liquidity prior to age 59½, unless the distribution takes the form of a life annuity, an additional 10% penalty would apply.
Reason 2: Insurance Component
Among the most common version of insurance is if the policyholder dies before annuitization begins, the heirs will receive the return of premiums paid. According to a 2001 article in the Journal of Risk and Insurance, while the median Mortality and Expense risk charge is 1.15%, the benefit is only worth between 0.01% and 0.1%, depending on purchase age.
Reason 3: Ability to Annuitize
Annuitization is the conversion of an annuity's value into a stream of income guaranteed for the policy holder's lifetime. While we cannot know what percent will eventually be annuitized, a 2000 paper reported that only about 1% of VAs had been annuitized.
Other Negatives
Investments inside the typical VA are both expensive and actively managed. Given the historical evidence on such funds, investors likely pay high prices for poor performance.
Sold vs. Bought
Why are so many VAs sold? It is because it is often in the best interest of the seller, not the buyer. The typical VA involves a high commission - 6%, or even more. The high commission may be why commissioned-based annuities also come with early surrender charges. The SEC became so concerned about abusive sales of VAs that they issued an "agency alert." They have also posted information to educate investors: www.sec.gov/investor/pubs/varannty.htm.
Reasons to Buy an Annuity
There are actually a few situations where the purchase of an annuity may make sense.
A) An individual wants to invest in a tax inefficient asset class such as REITS and does not have any room in tax-advantaged accounts. This makes sense if the annuity is low-cost, no surrender charge, and preferably has passive investment options. TIAA-CREF, Vanguard, AEGON, and others offer such VAs. Such annuities might also be good choices for those investors who currently own high cost VAs. A 1035 exchange from one annuity to another occurs without triggering taxes.
B) To one degree or another, many states protect assets in VAs from creditors. Doctors worried about malpractice suits, for example, might consider VAs. Because the laws are complex investors should consult their attorney before buying a VA for this purpose.
Summary
Investors are often tempted to buy products that offer seemingly attractive benefits. Unfortunately, the benefits are often either illusory or are accompanied by excessive costs. This is why VAs generally fall into the category of products meant to be sold, not bought. Education (or a fee-only advisor who is unbiased by commissioned-based compensation) is the armor that can protect investors from being misled.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.