Deferred Variable Annuities: A Poor Choice for Long-Term Investors
When you say the word annuity, most normal people think: "safe investment." Annuities are those payments you are guaranteed to receive every month until you die. For most people, it doesn't feel any safer than that.
The thing is, not everything called an annuity is safe.
In general, there are two classes of annuities: fixed annuities and variable annuities. Fixed annuities are ultra safe and cannot go down in value, but they have low investment returns. Variable annuities offer the opportunity to invest in markets, but just like investing in markets in a mutual fund, you can lose money in a variable annuity. In other words, variable annuities are not necessarily safe.
There is also another dimension to annuities: immediate vs. deferred: "Immediate annuities" start a regular stream of income immediately upon purchasing the annuity. Deferred annuities are essentially an investment account that (hopefully) grows over time until the client decides to annuitize the annuity, thereby starting the income stream.
Now I'm ok with immediate annuities. Immediate annuities can play a role in certain client situations by providing an immediate guaranteed stream of income.
Deferred fixed annuities can play a useful role in some situations. In particular, Deferred Income Annuities ("DIAs") and Qualified Longevity Annuity Contracts ("QLACs") can be a useful tool to manage longevity risk.
But I have yet to meet a deferred variable annuity that I like. And I really hate most deferred variable annuity products.
“Deferred variable annuities were an innovative product back in the 1950s. But today, no matter what your investment need is, deferred variable annuities are almost never the right investment vehicle.”
Before proceeding further, it's useful to provide a bit of a history lesson on annuities.
Annuities are a very old insurance product. For centuries, people have bought contracts that provide a stream of guaranteed income.
But starting after World War II, new forms of annuities started to be introduced. In 1952, TIAA introduced the College Retirement Equities Fund, better known as CREF, which was the first variable annuity. This was a really innovative product back then, as it enabled pensioners to get access to higher returns than what was offered by the traditional pension offered by TIAA.
Over the next few decades, lots of insurance companies introduced variable annuity products that anyone could buy. And variable annuities served a role much like mutual funds before mutual funds really started to emerge in the 1980s.
Variable annuities, especially those sold through an agent, generally have three big downsides: high costs, surrender fee periods, and complex rider options.
Especially today, variable annuities are significantly more expensive that what you would pay for similar ETF and mutual fund investment products, and unlike ETFs and almost all mutual funds, it can cost a lot of money if you want to get out of deferred annuity in the first few years of the contract.
Moreover, variable annuities offer a mixed bag of tax advantages and disadvantages. It is true that a deferred annuity allows you to defer gains until withdrawal like an IRA; however, there are significant disadvantages in investing money in a deferred variable annuity:
Like an IRA, all gains are taxed as ordinary income, even gains generated from stock market investment options.
Unlike an IRA, the tax rules are that all withdrawals from deferred annuity are taxed as gains until the basis is achieved. This makes withdrawing money from a deferred annuity complicated from a tax planning standpoint.
Unlike in a taxable brokerage account, money in a deferred annuity does not receive a step-up in basis upon death.
Another history lesson: variable annuities were more attractive before capital gains tax rates were lowered in the 1990s.
The change in tax law created a larger gap between capital gains tax rates and ordinary income tax rates. This reduction in capital gains tax rates made variable annuities a much less attractive investment vehicle from tax standpoint, especially for equities holdings within variable annuity vehicles.
Today, investors have lots access to lots of low cost investment options, and if I'm being honest, there is little reason to buy a deferred variable annuity. Yet despite the fact that variable annuities are vastly inferior in terms of cost, lots and lots of high-cost variable annuities still get sold.
Below is an illustrative, but typical, situation that I have run into with my clients regarding variable annuities:
Household consists of two 55-year old spouses with total retirement and non-retirement assets of $800,000 who are planning to retire in 10 years.
The clients bought a deferred non-qualified $200,000 variable annuity 3 years ago before I started working with them.
The variable annuity has a 7-year surrender fee period; so in year 4, the surrender charge is now 4%
The annuity has the following fees:
1.3% base fee
Average investment management fee of 0.7%
Riders that add anywhere between an additional 0.5% to 1.5%. The riders may offer guaranteed income and / or guaranteed death benefit.
So the client is generally paying between 2.5%-3.5% of the account value every year for this variable annuity.
The client's investments are allocated 80% in equities and 20% in fixed income.
Here is why I hate this product: a client could take that $200,000 and instead buy a 80% stocks / 20% bonds mutual fund that costs 0.15% per year. But if they're buying a variable annuity, they're generally paying an additional 2.00% per year, if not more. For a $200,000 annuity, that's around $4,000 of money lost in fees every year.
This is where the insurance folks chime in and say: "Yes, but a deferred variable annuity offers riders that provide guaranteed income, and that's where the value is." And I say, humbug.
A guaranteed income rider comes in lots of flavors, but essentially works like this: a variable annuity could experience losses. But if you buy the guaranteed income rider, the insurance company guarantees that your income for life won't be less than $x per month, even if the value of the annuity goes down. How this is structured in practice can vary from product to product, and it can be very hard for even financial professionals to understand the various scenarios of how much you would eventually make in monthly income.
In the meantime, the client is paying a lot of money to the insurance company in base annuity fees plus the rider fees, and these costs are eating into a lot of the potential investment gains.
In my view, stressing about guaranteed retirement income is not a problem to worry about in your 50s.
Even when you're 5-10 years away from retirement, you want all of your investments to be working for you.
If you bought this annuity at age 55 and planning to retire at age 65, you would be paying at least 20% of the starting account value in fees, and probably more than that. In other words, the real guarantee from buying a typical deferred variable annuity at age 55 is that you will lose 1/5th of your account value by the time that you turn 65. Why would anyone do this?
The time to worry about locking in guaranteed income is when you're actually at retirement age.
And that is when a client can start thinking about including an income annuity or longevity annuity in the overall portfolio to manage risk.
Unfortunately, I have had several clients that came to me with these types of annuities in place, and it has been hard telling them that (a) buying these was a mistake and (b) it's probably worth paying the surrender fee to get out of the contract. For one client in particular, legacy variable annuities purchased decades ago have created an incredibly challenging financial planning situation that will require years of ongoing complex tax and estate planning. And holding these annuities probably resulted in lost investment gains and higher taxes in the millions of dollars.
“The real guarantee from buying a typical deferred variable annuity at age 55 is that you will lose 1/5th of your initial account value in fees by the time that you turn 65. Why would anyone do this?”
One piece of relatively good news is that some insurers have introduced low-cost "investment only variable annuities" in the past few years that are available to through fee-only advisors.
These variable annuities have significantly lower costs than what is available through brokers and agents and also often come with no surrender fee period. But they are still much higher cost than index ETFs and mutual funds. And they still generally have a tax disadvantage relative to taxable brokerage accounts for asset classes that generate capital gains.
Deferred variable annuities were an innovative product in the middle of the 20th century. But today, no matter what your investment need is, deferred variable annuities are almost never the right investment vehicle. There are much, much less expensive investment options out there among ETFs and mutual funds. And there are even ETF options that provide "insurance-like" protections against investment losses, such as buffered outcome ETFs.
My advice to all investors: (i) don't buy a deferred variable annuity, (ii) certainly don't buy a deferred variable annuity a long time before retirement age, and (iii) most certainly don't buy a variable annuity without talking to a fee-only financial advisor first. It's a product whose time has largely come and gone.
And if you're currently holding a deferred variable annuity, you really should reach out to fee-only financial advisor to see if it makes sense to hold onto it or to pay the surrender charge to get out of the contract. A fee-only advisor with significant experience analyzing these annuities can help you figure out the best way forward to help you achieve your goals while managing risk.