Thoughts on Variable Annuities

Since their introduction in the late 1940’s, variable annuities have had a fairly colorful history.  Along with the heaps of praise they garnered during the stock market bull runs they have also amassed a fair share of criticism especially during market declines.  At the height of their popularity in the 1980’s variable annuities caught the attention of regulators and annuity critics alike.  After all of the dust settled, the final analysis remains essentially the same.  A variable annuity, issued by the right annuity provider, can be a tremendous investment vehicle, however, it is definitely not for everybody.

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Where to Start

There’s no question that variable annuities deserve careful scrutiny and due diligence as a consideration by any potential investor.  Sold by prospectus, and with required full disclosure, there’s little left to the imagination for those willing to take the time to conduct a full study of their viability and suitability as a long term investment.  The problem is the prospectus is loaded with technical jargon and legalese that only a CPA can completely understand. The devil is in the details and most people have a devil of a time understanding the details.

By understanding the primary features, guarantees, limitations and restrictions inherent in the variable annuity product, those people who are intimate with their own goals, priorities and risk tolerances will be able to make a quick determination as to whether it might be an appropriate fit for their financial portfolio.

How to Determine if Variable Annuities are a Fit

It may be easier to identify those for whom a variable annuity is not suitable.  Anyone who meets any of these criteria can simply stop reading and move on to other alternatives: 

  • Anyone  who hasn’t taken the time to fully understand their personal financial situation
  • Younger people, at the beginning stage of their accumulation years
  • Anyone who gets the least bit queasy from market roller coaster rides
  • If there’s still a lot of room for deductible contributions to qualified retirement plans
  • If liquidity, or access to cash, is an overriding concern
  •  Retirees or anyone who doesn’t have a need for long term, tax favored growth on investments

That narrows it down to those people with some tolerance for risk, a long term horizon, excess cash to invest, tax considerations, familiarity with financial markets and a desire for certain guarantees.  The key qualification is that potential investors have a clear understanding of their financial situation without which they couldn’t possibly know if variable annuities are suitable.

Knowing your own financial situation, the individual product features and provisions can then be evaluated to determine how well they match your own needs, preferences, priorities and risk tolerance. Because it’s is unlikely that a positive match can be found for each and every feature or provision, in most any investment vehicle, it’s important to balance priorities with preferences and risk tolerance. 

For instance if you rank your preference for growth as an 8 and you rank your tolerance for risk lower at a 3, you will need balance the two in order to arrive at an acceptable medium. Variable annuities enable investors to design an investment portfolio  that can fit within a wide range of preferences, priorities and risk tolerance.

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Key Variable Annuity Features to Evaluate

Investment Options

Like mutual funds, the accumulation component consists of a family of different funds, including stocks, bonds, cash, and fixed securities, that allow for proper diversification and  allocation of funds according to risk tolerance and preferences.

Lifetime Income

It is an annuity which is an instrument that is designed to generate an income that your cannot outlive.

Guaranteed Principle

An annuity is also a form of a life insurance contract and includes a death benefit that guarantees that a set amount, usually your invested principle, is paid to your beneficiaries at your death.

Tax Deferral

Under current tax law, funds that accumulate inside an annuity are allowed to grow without incurring current income taxes. The accumulated funds will be taxed  as ordinary income upon withdrawal or when received as periodic payment. The IRS will levy a 10% penalty for any withdrawal prior to age 59 ½

Guaranteed Minimum Income Benefit

Usually an option and an additional cost, this important benefit guarantees a minimum amount of income that will protect against market losses.

Surrender Fees

Variable annuities require a long term horizon so if there is an unexpected need for a cash withdrawal in the early stage of accumulation, the provider will deduct a surrender fee. These fees start out in the 7% to 10% range in the first year and then are reduced to 0% at the end of the early surrender window, typically 7 to 10 years. 

Investment and insurance expenses

One of the criticisms of variable annuities are the higher expenses, relative to other investment vehicles. These expenses, which average 2.4% (versus an average of 1.3% in mutual funds)of the accumulation accounts, cover investment management fees, mortality charges, and administrative costs. Many variable annuity investors feel as though the 1% difference in costs is a fair price to pay for the added guarantees and that the tax deferral more than offsets the small additional cost.

Tax Free Exchange

The current tax law accommodate those who grow unhappy with the performance of their annuities by allowing them to switch to another annuity provider. Caution should apply if the surrender of the existing accumulation accounts occurs within the surrender fee window and with the understanding that a new surrender period will start with the switch to the new annuity.

An in depth study of the prospectus and a sample variable annuity contract is essential prior to making a final decision, however, an evaluation of these key features in light of your own particular needs, preferences, priorities and risk tolerance will enable you to determine whether you are a fit and the time spent with the prospectus would be of any value.

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