Ever been pitched a variable annuity? If you haven’t yet, there is a good chance you will be offered one at some point. Read on to find out nine things that annuity salesman may not tell you.
- The Fees Are Expensive
Most variable annuities charge a Mortality & Expense fee and an Administration fee. You might also have a rider attached to your annuity, which charges a fee, and you may pay an annual account fee. Finally, the mutual funds that you invest in through the annuity also charge a variety of fees. Notice that the word ‘fee’ seems to be coming up a lot?The total is substantial. NOT including riders, the average annual fee for a variable annuity is 2.25%. In a $500,000 variable annuity, you would pay about $11,250 a year in fees.
- Mutual Fund Choices Are Limited & Expensive
Out of the 2.25%, generally about 1% results from mutual fund fees. While any investment fund will have some expense, you can purchase a variety of index funds for about 1/20th of 1%. Additionally, the choices inside variable annuities are limited. Of course, the mutual fund companies pay money to the annuity company to get their funds offered. That cost gets passed on to you, the annuity owner.
I have seen many people purchase annuities because they are looking for something “safe” or “guaranteed.” It’s a powerful sales mantra, and one the annuity salesman generally repeats ad nauseam. The simple truth is the variable annuity itself has zero guarantees. Investing in stocks and bonds inside a variable annuity gives you the exact same risk as purchasing the same stocks and bonds outside the annuity.To get this guarantee, your annuity must have an attached income rider. Sounds great, except for two things: that income rider is not free and it probably does not work the way you think it does.
- Income Rider
The fee for the income rider varies from company to company. It also might vary depending on how aggressive your investment allocation is. Generally, these riders might cost anywhere from .7% to 1.3%. So, how does it work?Annuities calculate two different amounts: your contract value and the “income base” or “withdrawal base.” Your contract value is your account value. If you die, this is what your beneficiary gets, unless you have a death benefit rider (that’s a story for another time.)
The income base is usually guaranteed to grow by a set percentage each year. Here’s the kicker: when you start to take distributions from the annuity, you take them from your contract value, NOT the “income base.” Furthermore, the annuity contract dictates how much you are allowed to withdraw; if you take more, your income base will be lowered. The only time the insurance company pays you anything is if you completely deplete your assets first! Unfortunately, though it is complicated, the simple truth is this: the annuity company did not set all of these riders up so they could lose money on them.
- The Tax Deferral Is Redundant Or Inefficient
Salespeople love to sell annuities as tax-deferred investment vehicles. However, if you have an IRA, 401(k)s, and other workplace retirement plan, you are already able to take advantage of tax-deferred investment growth. So, purchasing a variable annuity inside of something like an IRA is redundant.Even if you max out your tax-deferral options, think twice before buying that annuity with non-IRA money. When you withdraw from the annuity, your earnings will be taxed at ordinary income rates. For most people the ordinary income rate will be substantially higher than the long-term capital gains rate.
So, can you get tax deferred investment growth and pay the lower capital gains tax rate? Largely, yes. If you simply buy stocks, mutual funds or ETFs in a non-IRA account, you will only be taxed on dividends. You will not owe any tax on the growth of your investments until you sell the investment. So, if you hold onto the same investment for years, you will achieve tax-deferred investment growth. When you do sell the investment, you will only pay the long-term capital gains tax rate. Currently, that would be 15% for most people, but it maxes out at 20%.
Additionally, when a beneficiary inherits investments held in your brokerage account, he or she does not inherit your cost basis. That is, the gain in the investment is essentially reset to zero as of the time they inherited it. In such a case, your initial investment was mostly tax-deferred and entirely tax free to your heirs. Unfortunately, if you own a non-qualified variable annuity, your heirs get…..
- No Step Up In Cost Basis
A non-spouse beneficiary who inherits a non-qualified variable annuity does not get a step-up in cost basis; he or she will need to pay tax on all of the earnings in the annuity upon inheriting it. Even worse, those earnings are taxed at the ordinary income rate. This is something many people do not think about at the time of purchase.
- They Get You Coming Or Going
So now that you have all of this information, you might decide you want to rid yourself of your variable annuity. Unfortunately, the insurance company will generally get you coming or going. Oftentimes, annuities will charge a sales charge. So, when you invest they charge you a set percentage of your investment; that money is gone forever.If the annuity company did not charge you a sales charge, it will likely have a surrender schedule. The surrender schedule dictates how much money you will have to pay the insurance company to get out of the contract. Generally, the surrender charge starts out high (5% or higher) and reduces over time.
Unfortunately, once you have purchased an annuity with an active surrender charge, you are on the hook for a substantial amount of money no matter what. If you sell the annuity, you will be required to pay a surrender charge. If you choose to keep the annuity to avoid paying the surrender charge, you will still pay all of the yearly expenses the annuity assesses you.
So, why would anyone sell a product like this?
- They Might Have a Quota
If the salesperson wants to keep his or her job, the only option might be to sell variable annuities. Many firms have quotas on variable annuity sales. Here’s one example from All State. So, it could be that your agent does not want to sell you the annuity but is feeling pressure from the firm. Unfortunately, annuity salespeople are mostly happy with the products. That’s because…..
9. Commissions Are Huge
In my opinion, the biggest reason variable annuities are so popular are because of the commissions, which can be as high as 10%. On a $250,000 annuity, that’s $25,000. It might be pretty hard to be unbiased with that kind of money on the line.Hopefully, these ten facts have allowed you to understand my view that annuities are sold more for the well-being of a broker’s pocketbook than the clients he or she purports to serve.