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Because of high fees and volatility and other reasons, many planners discourage the use of variable annuities as a vehicle to achieve income security, especially for retirement-age people looking to avoid risk. Many insurance salespeople, however, recommend them for retirement savings – and then often place them in custodial accounts.
As a result, the retirement saver experiences high fees and charges, lower returns compared to the broader markets over long periods of time – and has limited access to their own account.
For these reasons, many planners discourage the use of variable annuities as a means to achieve retirement income security. On the other hand, people often have questions about variable annuities, both inside and outside of retirement accounts.
While variable annuities have some investment-like characteristics, they are fundamentally insurance products, not investment products. They are designed to remove some of the uncertainty of stock and bond market investing, transferring the risk from the annuity owner to the insurance company – for a price.
Here's how they work.
The annuity owner contributes money, or premium, to an insurance company. The insurance company places these funds into one or more mutual-fund-like pools of money, called subaccounts.
In return, the annuity owner receives a contract with certain guarantees that are based on the value of the contract. Unlike fixed annuities, however, the annuity owner assumes some risk of loss. The value of the contract could increase or decline, based on the underlying performance of these subaccounts.
Most people who buy annuities elect to buy a rider – an add-on benefit – that guarantees a certain minimum income when the owner annuitizes, or begins taking a stream of income from the contract.
If the stock or bond market does well, the annuity owners should experience a better return than they would have received in conservative vehicles like bank CDs or treasury bonds. Annuity owners also receive the benefit of tax deferral until they begin taking income.
These advantages, of course, are offset by higher fee structures. The guarantees in annuity contracts aren't free: The more risk the annuity company takes off of the investor's shoulders, the higher the fee structure is going to be, one way or the other.
With variable annuities, your fees are stacked one on top of the other. The contract itself has an ongoing fee. Then there will generally be another fee for every rider, benefit or guarantee you elect to add on to the annuity.
And then on top of that, there will be another fee within each sub-account, similar to a mutual fund expense ratio.
On average, the total fee stack within variable annuities usually runs from about 2% to 2.5%. There are a few variable annuities on the market with fees as high as 3.95%. The average, according to the American Association of Individual Investors, is around 3%.
In the short run, if markets crash, the guarantees could look good, and even appear worth paying an additional 2.5% compared to the costs of a mutual fund portfolio with no such guarantees or protections.
Over long periods of time, the weight of the additional fees in the variable annuity is likely to make itself felt.
Annuity owners also sacrifice a lot of liquidity. Surrender charges typically start at 7%, and gradually decline over 7 to 10 years. If you decide the annuity no longer fits your needs, you'll have to pay a significant surrender charge to transfer your money out of it, or get it back.
Some advisors will set up variable annuities within a custodial account. This allows them to charge an additional assets-under-management fee (AUM) just to hold the assets on your behalf. This typically adds another 1% to the annuity owner's annual costs. That fee gets charged on top of all the fees in the annuity itself – and pushes the cost of ownership even higher, to between 3% and 5%.
But once the annuity is bought, the advisor does next to nothing to justify his or her fees. For that portion of the portfolio in the variable annuity, the AUM fee can generate thousands of dollars for the advisor – but it buys no benefit for the client.
Traditionally, when you decide to purchase an annuity, you become the owner and annuitant of the contract. You then list someone else as your primary beneficiary for the annuity contract. It's also a good idea to list a contingent beneficiary in case significant life events occur.
Unfortunately, if you purchased your variable annuity from a broker, they will list their firm as the custodial owner of your investment. This allows the broker to have discretionary authority over your account and buy and sell securities without your consent. They may alter asset allocations, beneficiaries and other preferences.
In a traditional investment account, you want your authorized broker to have wide authority to move your money out of harm's way and make time-sensitive trades on your behalf if necessary. However, with a variable annuity, you typically need to sign a form to make allocation changes and send paperwork to the insurance company for processing. With a variable annuity, there is no need for quick trading. This eliminates the need for giving a broker discretionary authority over your variable annuity.
Your loss of independent control over your money is a major drawback when your variable annuity is held in a custodial account.
One reason brokers relish the role of custodial owner is because of the control they have over every transaction in your variable annuity. This includes any type of withdrawal you want to make, whether a complete surrender of your annuity or just a simple required minimum distribution (RMD). The custodial owner must sign off on any changes to the variable annuity contract.
If you want to change investment allocations inside your variable annuity, the broker may have to sign a reallocation document. If you wish to get out of a variable annuity and into a safer investment, you may need your broker or your broker's office to sign off on the transfer. In a custodial account, they have the final say whether you can transfer your own money.
Variable annuities are relatively complex instruments, with significant expenses and fees compared to mutual fund and ETF alternatives. The insurance features in these products, such as cost-of-living riders, guaranteed minimum withdrawal benefits and guaranteed minimum income benefits, as well as the death benefit, can have real value.
The tax deferral feature, as well as the option to make tax-free exchanges between annuities can also be valuable – especially to those in higher tax brackets, and those who don't qualify to contribute to IRAs or Roth IRAs, or who are already contributing the maximum.
Some people also value annuities of any stripe where state laws provide some protection against the claims of creditors.
Other retirement savers, however, should consider the costs and tradeoffs carefully. In many cases, the saver is better served with a diverse portfolio of mutual funds, bonds, bond ladders and straight lifetime annuities for income.
Alliance America is an insurance and financial services company. Our financial planners and retirement income certified professionals can assist you in maximizing your retirement resources and help you to achieve your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.
