Variable annuities: Custodial ownership by brokerage firms can chip away at returns

As investors search for ways to secure their retirement, they often consider variable annuities as a possible investment option. However, before making this investment, it is essential to understand how variable annuities sold through brokerage firms are owned by the brokerage firms in a custodial ownership. In this article, we will explain what variable annuities are, how they work, the role of brokerage firms and the ownership structure.

What is a variable annuity?

A variable annuity is a financial product that combines elements of insurance and investment. It is a contract between an investor and an insurance company, where the investor pays a premium to the insurer in exchange for a series of payments in the future. The payments may be immediate or deferred to a future date, and the amount of payment is determined by the performance of the underlying investments in the annuity.

How does a variable annuity work?

The premium paid by the investor is used to buy units in a portfolio of underlying investments such as stocks, bonds and mutual funds. The investor can choose the type of underlying investments that match their financial goals and risk tolerance. The performance of the underlying investments affects the value of the annuity and the amount of future payments. The investor can also choose to receive a lump sum payment or a series of payments over a specified period.

What is the role of brokerage firms in variable annuities?

Brokerage firms play a crucial role in the sale and distribution of variable annuities. They act as intermediaries between the investor and the insurance company. Brokerage firms market variable annuities to investors and facilitate the purchase and sale of these investments. They also provide advice and guidance to investors on which variable annuities are suitable for their financial goals and risk tolerance.

Brokerage firms typically earn commissions on the sale of variable annuities. This means that they make money when they sell a variable annuity to an investor. As a result, it is important for investors to be aware of the potential conflicts of interest that can exist when working with a brokerage firm.

For example, a brokerage firm may be more likely to recommend a variable annuity that pays a high commission, even if it is not the best product for the investor's needs. It is important for investors to ask their brokerage firm about the fees and expenses associated with any variable annuity that they are considering purchasing.

Investors should also be aware that variable annuities are complex products. It is important to understand the terms of the contract before you purchase a variable annuity. You should also work with a financial professional who can help you to understand the risks and benefits of variable annuities and make sure that they are right for your needs.

Custodial ownership by brokerage firms

When an investor purchases a variable annuity through a brokerage firm, the ownership of the annuity is held in a custodial ownership by the brokerage firm. When you purchase a variable annuity from a brokerage firm, the brokerage firm typically becomes the custodian of the annuity. This means that the brokerage firm holds the annuity in its name and is responsible for managing the account.

The brokerage firm is responsible for holding and safeguarding the investor's investment and ensuring that the investment is managed in accordance with the terms of the annuity contract.

There are a few reasons why brokerage firms might want to be the custodian of a variable annuity. First, it allows the brokerage firm to earn additional fees. Second, it gives the brokerage firm more control over the account. Third, it allows the brokerage firm to sell other products and services to the annuity owner.

However, there are also some potential drawbacks to having a brokerage firm as the custodian of your variable annuity. First, it can make it more difficult to transfer the annuity to another custodian. Second, it can give the brokerage firm more control over your money, which could lead to conflicts of interest. Third, it could make it more difficult to access your money in an emergency.

Advantages of custodial ownership by brokerage firms

The custodial ownership by brokerage firms provides some advantages to investors. First, it provides an extra layer of protection to the investor's investment. The brokerage firm is responsible for holding and safeguarding the investment, ensuring that it is managed in accordance with the terms of the annuity contract. Second, the custodial ownership simplifies the administrative process for the investor. The brokerage firm takes care of all administrative tasks, such as record-keeping, tax reporting and distributing payments. Third, it allows the investor to consolidate all their investments in one place, making it easier to manage their portfolio.

Risks of custodial ownership by brokerage firms

While custodial ownership provides some advantages, it also comes with several risks. The brokerage firm may charge fees for its services, such as account maintenance fees and transaction fees. These fees can reduce the investor's return on investment. When a brokerage firm holds a variable annuity in its name as a custodial owner, there are several potential issues that can arise. Some of these issues include:

• Conflicts of interest: The brokerage firm may have a conflict of interest when it comes to recommending the variable annuity to its customers. Since the brokerage firm is the custodial owner of the annuity, it may have an incentive to recommend it to customers, even if it is not the best investment option for them. For instance, let’s say a brokerage firm holds a variable annuity in its name, and the annuity has high fees and limited investment options. The customer, on the other hand, is looking for a low-cost investment with a wide range of investment options to diversify their portfolio. In this scenario, the brokerage firm may still recommend the variable annuity to the customer, even though it is not the best option for them. The brokerage firm may do this to generate more revenue from the fees associated with the annuity or because they have a financial incentive to promote the annuity to meet sales goals or receive a commission. This conflict of interest can result in the customer making an investment that is not suitable for their financial goals or objectives, and it could harm their long-term financial well-being. It is important for investors to be aware of potential conflicts of interest when receiving investment advice and to work with a financial advisor who operates with transparency and puts the investor's best interests first.


• Higher fees: When the brokerage firm holds the annuity in its name, it may charge additional fees for custodial services, which can further increase the overall cost of the investment. Variable annuities typically come with higher fees than other investment products, such as mutual funds, exchange-traded funds (ETFs) or individual stocks. The fees associated with variable annuities can vary based on the insurance company that issued the annuity and the specific features of the product, but they generally include mortality and expense (M&E) fees and investment management fees. M&E fees cover the insurance risk and administrative costs associated with the annuity. M&E fees typically range from 1% to 1.5% of the account value per year. Meanwhile, investment management fees are charged by the investment managers who oversee the underlying mutual funds or other investments held within the annuity. These fees can range from 0.5% to 1.5% of the account value per year. Mutual funds typically have expense ratios ranging from 0.2% to 1%, while ETFs have expense ratios ranging from 0.05% to 0.5%. Individual stocks may have no ongoing fees beyond the cost of the trade.


• Surrender charges: These are fees that may be charged if the investor withdraws funds from the annuity before a certain time period has elapsed. Surrender charges can range from 7% to 10% of the account value in the early years of the annuity contract. These charges are intended to discourage investors from withdrawing funds too soon and to help ensure that the insurance company issuing the annuity has sufficient time to recoup its costs. Surrender charges are typically calculated as a percentage of the account value, and the percentage charged decreases over time. For example, a variable annuity might have a surrender charge of 10% in the first year, 9% in the second year, 8% in the third year and so on until the surrender charge reaches zero. The surrender period for a variable annuity can vary, but it is usually between five and 10 years. If an investor withdraws funds from a variable annuity during the surrender period, the surrender charge will be deducted from the withdrawal amount. For example, if an investor has a $100,000 variable annuity with a 10% surrender charge in the first year and they withdraw $20,000, they would be charged a $2,000 surrender charge, leaving them with $18,000. It is important for investors to carefully consider the surrender charges associated with a variable annuity before investing, as they can be significant and can have a negative impact on the investor’s returns if they need to withdraw funds early. Investors should also be aware that surrender charges can vary between insurance companies and variable annuity products, so it is vitally important to read the contract carefully and understand all of the fees and charges associated with the annuity before investing.


• Limited investment options: When a brokerage firm holds a variable annuity in its name, the investment options may be limited to the products offered by the insurance company that issued the annuity. The insurance company issuing the annuity is responsible for selecting the investment options that will be available within the annuity contract. This means that the investment options available within a variable annuity are determined by the insurance company, not the brokerage firm that holds the annuity in its name. Since the brokerage firm is holding the annuity as a custodial owner, they do not have control over the investment options within the annuity. The brokerage firm is simply responsible for holding the annuity on behalf of the investor and providing custodial services, such as record-keeping and processing transactions. As a result, if an investor wants to invest in a specific mutual fund or other investment that is not offered within the annuity contract, they may not be able to do so if the brokerage firm is holding the annuity in its name. This can limit the investor’s ability to diversify their portfolio and may result in missed investment opportunities.


• Lack of transparency: Since the brokerage firm holds the variable annuity in its name, the investor may not have full visibility into the underlying investments and how they are performing. This lack of transparency can make it difficult for investors to make informed decisions about their investments. Insurance companies issuing variable annuities are not required to disclose the underlying investments held within the annuity to the brokerage firm or to the investor. As a result, the brokerage firm may not have full visibility into the investments held within the annuity, making it difficult for the investor to assess the performance of their investment. Also, variable annuities can be complex investment products that may hold a mix of mutual funds, subaccounts, and other investments. These investments can be difficult for investors to understand and may not be fully transparent. As the custodial owner of the variable annuity, the brokerage firm may have a conflict of interest when it comes to disclosing information about the underlying investments. The brokerage firm may benefit financially from keeping investors invested in the annuity, even if it is not the best option for the investor.


• Potential tax implications: Holding a variable annuity in the name of a brokerage firm can have tax implications. For example, if the annuity is held in a tax-deferred account, such as an IRA, the investor may be subject to additional taxes or penalties if they withdraw the funds before reaching retirement age. Also, when an investor makes withdrawals from a variable annuity, the withdrawals are generally taxed at ordinary income tax rates. This is in contrast to long-term capital gains tax rates, which are generally lower. If the investor withdraws funds from the annuity before reaching age 59 1/2, they may also be subject to a 10% early withdrawal penalty. If the variable annuity is held in a tax-deferred account, the investor will be required to take minimum distributions from the account after reaching age 72. The amount of the required distribution is calculated based on the account balance and the investor’s life expectancy. If the investor fails to take the required minimum distribution, they may be subject to a 50% penalty on the amount that should have been distributed.

Conclusion

Variable annuities sold through brokerage firms may provide investors with a way to potentially boost their retirement income. While custodial ownership by brokerage firms offers some advantages, it is important for investors to understand the risks and fees associated with this ownership structure. Investors should carefully consider their investment goals and risk tolerance. By doing so, investors can make an informed decision that aligns with their financial goals and values.