Some financial salespeople tout variable annuities as a better way protect your money or create retirement income. Even smart people can get caught up in the hype. This article will shed light on how they really work and what you can expect from them.
COSTS
Variable annuities are generally known to be expensive. Their costs can be broken into a handful of categories.
Mortality expenses. This is a fee charged to provide you with a death benefit, which is often nothing more than a guarantee to pay out at least what was put in. This variable annuity fee can range from .50% – 1.5% of the policy value per year.
Administrative expenses. Many variable annuity policies have a separate administrative fee to cover the cost of mailings and ongoing service. This fee can range from .10% – .30% of the policy value per year.
Investment expenses. Inside a variable annuity, the underlying stock and bond investment choices, called sub-accounts, will have an investment management fee which can range from .25% – 2.50% of the value in that account per year. It is common for insurance companies to use mutual fund managers but mark up the costs of their funds. And the more active a fund trades, the higher the implicit costs within the fund.
Surrender charges. Most policies pay an upfront commission to the person who sells the policy to you. A surrender charge is put on the variable annuity policy so that if you cancel the policy early, the insurance company can thus recoup the commission paid, commonly ranging from 4%-7%.
Additional cost of riders. Riders are extra features on your variable annuity policy that provide you with additional income guarantees or death benefits. Depending on the extent of the benefit, riders can cost .25% – 1.75% of the policy value per year.
INCOME RIDERS
You can purchase stock, bond, and mutual fund investments outside of an annuity. Therefore, with all the costs in these products, virtually the only logical reason you would purchase a variable annuity is for the potential rider benefits.
The basic idea of the most common income rider, the Guaranteed Living Withdrawal Benefit (GLWB), is relatively straightforward: to allow policyowners to remain invested in the markets with a chance for upside, while still having a guaranteed income floor. The income component is not based on the cash value but on the “income account value.”
These annuities are often marketed with a 5% or 7% growth guarantee, if you defer commencement of the income rider. But consumers are often confused or perhaps misled by this. How can you get a guaranteed 5% or 7% return? You cannot. The growth is not on the cash value but on the income account value.
Michael Kitces, a renowned retirement researcher, wrote, “a deeper analysis reveals that in the end, most retirees with a GLWB rider may do little more than pay a lot in annuity costs to receive a guarantee to just spend their own original contributions and nothing more. The challenge lies in the simple fact that GLWB riders extract any withdrawals against the policyowner’s own cash value first. Often the time it takes to actually reach the point where the policyowner has worked through their own cash value and into the insurance company’s pocket via the guarantee is actually longer than the client’s own life expectancy!”
Vanguard, a consumer-friendly company, offers a variable annuity with income rider. It will pay out 3.5% for life for a married couple under the age of 65. With both spouses aged 65-79, the payout is increased to 4.5%. Said another way, assuming no growth on the investments after fees, you spend your own money for the first 29 to 22 years, respectively. You’ll likely have to make it to your 90s to have a chance at collecting the insurance company’s money.
These riders commonly limit the amount of stock exposure you can have in the annuity. Once you consider the expected returns from a balanced stock and bond portfolio and then subtract the associated fees that can total more than 4%, it’s hard to see how you can expect to have growth in the annuity. When we analyze these for clients, we generally analyze the annuity assuming only the underlying guarantee is what is received. It’s irrational to assume something more.
