How Is a Variable Annuity Like a Bumblebee?

January 11th, 2010

The answer is: Both are not optimally designed for their primary activity.

Bumblebees fly, but their aerodynamic characteristics make aviation engineers shudder. Variable annuities are investment vehicles, but their packaging and operation – what we might call their investment-design characteristics – make radio and Internet commentators shudder with horror.

We aren’t called upon to vote on the existence of the bumblebee. We are, however, expected to vote with our portfolio allocations on the desirability of variable annuities. How should their ungainly structure and visible imperfections affect our vote?

“I Think That I Shall Never See… Fair Variable Annuity”

A variable annuity is an investment product wrapped up in the packaging of insurance. The insurance wrapper is there because of taxes. Insurance products, particularly life insurance, can accumulate value tax-deferred. One important reason for the rise of variable annuities in the late 1970s was the desire to use that tax-deferral to advantage without having to tie up money inside a life insurance policy. A variable annuity is a group of mutual-fund-like investment alternatives contained inside an insurance policy. While the insurance features of a variable annuity are genuine, their main purpose is to gain tax-deferral for the investments that accompany them.

The introduction of insurance as a pretext rather than for its own sake rates to introduce distortions into the product – and so it does.

The Cost-Heavy Body

The variable annuity’s investment performance is hampered by its cost-heavy structure in the same way that the bumblebee’s rotund body hampers its flight. The variable annuity’s sub-accounts are, in effect, mutual funds. Each fund generates management and administrative costs, just as any mutual fund does. However, variable annuities have other costs not found in mutual funds. The insurance company must set up a separate company to run the sub-accounts. The insurance features of the variable annuity, such as the death benefit, require reserves to be set aside and managed, just as the insurance features in an insurance company are. These extra layers of cost are added to the sub-account’s management and administrative fees and detract from the sub-account’s annual performance.

Comparing this ungainly cost structure to the sleek investment-dynamics of, say, a no-load index mutual fund is like comparing a bumblebee to a mosquito.

The Penalty-Driven Inertia

Just as bumblebees don’t flit from flower to flower with the agility of hummingbirds, so are variable annuities not conducive to rapid movement of money. Surrender charges ranging up to 10 years in duration (or even longer) claim a portion of funds withdrawn prior to the time stipulated in the annuity contract. The 10% penalty levied by the IRS on withdrawals prior to age 59 ½ already stamps the variable annuity as a retirement-oriented investment vehicle.

The Tax-Loaded Wings

Variable annuities offer tax deferral of gains, but deferral can only put off the evil day for so long. Eventually, tax must be paid. When that happens, variable annuities offer a significant disadvantage compared to other investment vehicles, such as mutual funds. Variable annuity gains are taxed as ordinary income, whereas mutual fund gains are taxed as long-term capital gains. The difference – 35%, depending on the particular tax bracket, compared to 15% – may be enough to wipe out the tax-deferral advantage conferred by variable annuities in the first instance.

Depending on individual circumstances, variable annuities may suffer other, more abstruse, tax disadvantages. One of those is the inability to harvest tax losses. All in all, the tax disadvantages of variable annuities are analogous to the bumblebee’s tiny wings having to lift its massive body.

Living Benefits: The Last Bumble

How would one expect an insurance company to refine its investment products? Make them more secure, right? Yet for critics of variable annuities, “living benefits” riders that offered guaranteed income, withdrawals and rate of return were simply the last bumble. Seeing guaranteed security as completely incompatible with equity investment and high rates of return, those critics accused insurance companies of acting in bad faith. When the financial crisis forced several companies to backtrack on promised benefits, this only confirmed the bad opinion the critics had already formed of insurance companies in general and variable annuities in particular.

Charlie Brown, Rodney Dangerfield and Variable Annuities

There is a curious mentality among investment commentators that refuses to give variable annuities their due. Like Charlie Brown, they are often treated with contempt. Like Rodney Dangerfield, they don’t get no respect.

Pinpointing the source of this disrespect is difficult. Part of it stems from their unlovely appearance. Part of it stems from the bad press that has tarred a financial asset with the same brush as the shady sales practices employed by its vendors. Those practices include selling variable annuities for residence inside the tax-advantaged retirement plans of investors. Since variable annuities already command tax-deferral, housing them inside an IRA or 401(k) offers no additional benefit but does lower their flexibility even further.

Part of the problem stems from the high commissions enjoyed by salespeople who sell variable annuities. Although high sales commissions are often treated as an abusive sales practice, nothing could be further from the truth. Sales commissions are a cost for which there should be a corresponding benefit. Only the lack of that benefit is problematic, and the problem is not fraud or abuse but simply poor business practice.

Bumblebees Fly, and So Do Variable Annuities

In spite of their disadvantages, bumblebees fly. Variable annuities are still valuable investment tools if employed judiciously. For younger investors, they can provide a liability shield for professionals and business owners, whose assets are at risk from litigation. For middle-aged and older investors, now at the peak of their earning abilities, variable annuities pick up the slack caused by contribution limits to retirement plans. There are no contribution limits to a variable annuity, which enables investors to enjoy the catch-up provisions designed to allow baby boomers to make up for lost retirement-investing time. There is even a theory that finds virtue in the high surrender charges and resulting low liquidity of variable-annuity investment. The penalties for premature withdrawal keep sub-account withdrawals well below mutual fund redemptions. This may allow sub-account managers to hold good investments longer than their mutual-fund counterparts, thus elevating variable annuity average returns above those for mutual funds.

Critics of variable annuities make valid and valuable points against this financial tool. Variable annuities possess certain inherently contradictory features that hamper their performance and limit their applicability. But within their limits, they are important and useful instruments. Their critics should profit from the example of the bumblebee.

Category: Annuities, Retirement Planning | Tags: , , ,

Comments are closed.