Variable Annuities

This article on variable annuities is aimed to recognize the problems with variable annuities, and go the extra mile to analyze each part of the variable annuity benefits (good or bad). 

It’s amazing when you read every document ever written on variable annuities, and study who the writer represents and how they are lining their pockets to pitch variable annuities…you quickly understand how the public in general (including newspaper reporters) have been “hood-winked” in believing that variable annuities were the panacea of the investment world.

Let’s evaluate each part of the variable annuity separately to analyze in detail.

Living Benefits:

Guarantee Minimum Income Benefit (GMIB):

1.      This benefit guarantees an annual income at 5%...regardless if you lose money in the sub-account (minus the annual fees for the benefit). Example: $100,000 @ 5% for 10 years = $162,889.46. But, the fee is .50% per year, so in essence you are receiving a 4.5%. So, $100,000 @ 4.5% for 10 years = $155,296.94. You could have gotten a traditional fixed annuity…without an annual fee and out-performed the future value of the GMIB benefit over the term of the product.

2.      There is a minimum 10 year holding period…which you must annuitize the product for life annuitization. By annuitizing the product it no longer has any future growth potential…which is very bad. Annuitization is irrevocable!

3.      By product design, the payout is the smallest monthly payout versus (as example: 5 year guaranteed period certain). You can design a recovery solution, based on annuitization (without annual fees) and produce twice as much monthly income over the life span of the client (versus a GMIB benefit). In addition, you can produce even more monthly income using a withdrawal only recovery solution (using fixed annuities only) without putting a hold on growth (with no annual fees) versus the GMIB benefit.

4.      If you chosen “life only” annuitization, which many do (to produce greater income streams than “life with 5 year period certain,” and you die next week…the entire account value goes to the insurance company (and your spouse gets nothing). If this happens, and people do die before their time, who do you think they are going to sue first?

5.      If you get an internal return of 1.3% on 5 year period certain (which is the best in the industry), what “miniscule” return could they reduce 1.3% based on “life” annuitization? People cannot live on air!

6.      Your GMIB future benefit is reduced by any withdrawals in excess of 5% within the 10 year holding period. I do not know of any middle class civilian who can live-off 5% annual income. Let’s say you withdrew $40,000 in 10yrs over the 5% annual ceiling limitation. Your $155,296.94 is now reduced to $115,296.94 ($155,296.94 - $40,000)…and this is the value the insurance company annuitizes (based on life annuitization). Are they actually kidding?

7.      Some insurance company’s have a provision to reduce the GMIB base “proportionate” to withdrawals…reducing your base benefit in 10 years significantly. If that was not bad enough, the insurance company reduces your annual annuitizied payout based on an age 10 years younger than your true age…reducing your annual payout even further!

8.      There are some companies with minimum annuitization of 2% (not counting rollbacks, ect.). Would be proud to tell anyone you are making 2% annually for the next 22 years?

Guaranteed Minimum Accumulation Benefit (GMAB):

1.      This benefit guarantees that your original investment principal will be returned…if you hold the account for a 10 year period in a fixed annuity within the variable annuity. Why are you purchasing a variable annuity, if you are really investing in a fixed annuity?

2.      You cannot take current income from the variable annuity, while in the holding period (which is usually 10 years long)…without reducing the so-called guarantee of recovery of principal.

3.      The insurance company charges you a fee of .50% for placing the investor into fixed annuity inside the variable annuity. But a fixed annuity is free without annual charges.

4.      Some companies will place you directly into a fixed account from the start, while others wait, try to time the market, and place you in a fixed account when there is a bull run…and you miss any explosive growth in your sub account.

5.      If I invested a $100,000 @ 4.5% for 10 years = $155,296.94 dollars. But the insurance company wants to charge .50% per year for a fixed annuity (when it should have been free)…and you only get my original principal back of $100,000 dollars. What happened to the $55,296.94? Are these guys kidding? I did not walk off the ship yesterday!

 Guaranteed Minimum Withdrawal Benefit (GMWB):

1.      Guarantees that a 5 to 7% of the original investment premium can be withdrawn annually until the initial investment value is liquidated (regardless of the market performance of the sub-accounts).

2.      65% of all senior citizens will have financial difficulty. Seniors need increasing income needs to deal with medication, spousal health needs, un-known emergencies (and everyone has emergencies), and the enjoyment of life in general.

3.      The GMWB is a limitation cap on income, and penalizes the insured for excess withdrawals. Example: Let’s say the GMWB is 7% of the original investment principal of $100,000. Thus, the payout is 14.28 years. So, the insured will get $7,000 each year for 14.28 years…which total $100,000. Versus, if you invested $100,000 in a traditional fixed annuity @ 5% for 14.28 years your balance would be $194,917. You lost $94,917 in the math and were charged an annual fee of .50% per year.

4.      Let’s say you needed more income than 7% per year…which 65% of all senior citizens needs more income than their budget will allow. So, let’s say you started out with $100,000 and your GMWB maximum annual withdrawal was $7,000 (7%) and you needed $10,000…and lets’ say your account value has dropped to $70,000. Your account value minus your withdrawal of $10,000 is your new GMWB benefit which is reset to $60,000 ($70,000 - $10,000). $60,000 divided by 14.28 years equals a new GMWB benefit of $4,201.68 dollars for 14.28 years…and this does not factor-in the penalty charged against your account value! This is insane!

5.      You must wait a year for GMWB benefit to be activated. What happens if you need money today (day 30) from your contract anniversary date? You’re going to suffer a steep penalty…one way or another! The surrender charges can re-adjust the base value for the GMWB benefit! In many cases you must wait a minimum of 5 years before receiving benefits under the GMWB benefit (or until the surrender charge has expired).

6.      GMWB payouts structures are annual or semi-annual. There are no monthly payout provisions for the GMWB. This type of payout (annual or semi-annual) is difficult to manage by most people, since they have lows and highs in their spending habits and cannot stick to absolutes in their spending patterns.

7.      You are required to invest in the insurance companies asset allocation models, designed to produce a return for the insurance company with a target of 9%.  Insurance company only owes the insured (7% as example) for 14.28 years. So, the insurance company spread is a gain of 2%. 40% of the asset allocation model is invested in a mutual fund account owned by the insurance company. I wonder how much hidden managements fees are earned by owning the bond fund for the asset allocation sub-account?

8.      There is no “cumulative” withdrawal provision to the GMWB benefits. Say, if you got some taxes back from the IRS, and decided not to take the GMWB benefit of 7% for this year…you cannot take 14% next year.

9.      You cannot take lump-sum withdrawals on the GMWB benefit.

10.  The GMWB rider cannot be used with IRA’s…since the RMD may exceed the GMWB payout limitation.

11.  The GMWB can be “stepped-up” to higher payout…for an additional fee .50% (or higher). So, your total annual GMWB rises from .50% to 1.00% annually. What does this do? Every 5 years (as example), if your account value is positive, your GMWB benefit is recalculated for another 14.28 years. Let’s say, you start out with $100,000 and five years latter your account value is worth $127,628.15 dollars. Instead of getting $7,000 for 14.28 years…you will get $8,937 dollars for 14.28 years. Only two big problems with this feature. One your account value could be negative in the future…thus you paid an additional .50% per year over 5 years (for nothing). If you speak to several hundred planners and ask them if they have seen any positive account values in variable annuities…they will give only sad stories. The other problem is the insurance company can raise their fees if you have a positive account (at the time of step-up), since and they have to “shell-out” more money than they planned in their actuarial studies. The insurance company has the ability to raise fees…and they will!

12.  There is a 30 day windows for “stepped-up” provisions. This means if you decide after your account goes positive (at the 5 year mark) and you would like a “stepped-up” GMWB benefit…and 30 days go by (too bad). Begging will not help!

13.  If your GMWB account is terminated…you may lose all rights to a death benefit.

14.  If the death of the owner occurs, the GMWB benefit will be paid in either a lump sum (which could result in a tax liability), or the remaining benefits will be paid out over 5 years to the spouse. If payment is to a contingent beneficiary, a lump sum payment will be paid out…and the taxes will be owed all at once.

15.  All withdrawals are subject to “ordinary” income tax, and any withdrawal before age 59.5 is subject to a 10% excise tax penalty.

16.  If there is a bonus provision for the GMWB, you may lose all bonuses if you take an excessive withdrawal above your GMWB limitation (or changes are made to the “step-up” provision). Why give a bonus when you have some “sneaky” way of taking it away? Some bonus provisions have waiting limits of 5 years or longer.

17.  Basically, the GMWB benefit is an account value tied to a put option. The put option is only exercised if the account value goes to zero. The insurance company is charging .50% per year for the GMWB benefit. But a 2006 study shows that a put option strategy may cost anywhere between .75% to 1.60% for the rider. Thus, the GMWB benefit may be under priced…which could lead to defaults in the future by the insurance company (conjecture only). The guarantees are only as good as the insurance company assets to back those guarantees.

Guaranteed Minimum Withdrawal Benefit for Life (GMWBFL):

1.      This type of benefit guarantees an income for the life of the annuitant (with the option of an income guarantee for life for the spouse)…based on a quasi-withdrawal. A fixed percentage can be withdrawn at 3% to 5% annually as long as the annuitant lives. These payments continue regardless of the account value is zero.

2.      This guarantee only guarantees your money back…nothing more.

3.      The cost of this rider is .60% for a single life GMWBFL benefit (with a cap of 1% annually), and a life + spousal GMWBFL benefit costing .70 (with a cap of 1.25% annually). Very expensive.

4.      This can only be activated when the annuitant turns 59.5 or 65 years old (depending on the policy). Versus an immediate annuity…when can be annuitized at any age. In addition, a normal fixed annuity can take a withdrawal at 59.5 without an excise tax penalty. There are no limitations at the starting age to take a withdrawal (but may be subject to a 10% excise tax penalty as with all annuities).

5.      According to an actuarial table, a 65 year old that invested $100,000 in a variable annuity with a GMWBFL benefit would receive $5,000 dollars annually. If you choose “life + spouse” GMWBLF benefit…you would receive even less. By contrast, an annuitant (age 65) who purchased an immediate annuity would receive $7,644 for a female or $8,692 for a male (since he does not live as long…statistically). If you came up to me and asked do you want $5,000 (with an annual fee) or $8,692 annually (with no fee)…I would choose the immediate annuity. If an annuitant age 65 statistically only lived 22 years (to age 87), a $5,000 dollar annual payout (under GMWBFL) would total $110,000. A payout with an immediate annuity at $8,692 annually for 22 years would be $191,224…almost twice as much income. For both the GMWBFL and the immediate annuity…you receive only income, no additional recovery of principal. The planner is going to sell the variable annuity to the public for a 4% commission versus a 1.5% commission for the immediate annuity, while the public is unaware of the income limitation & the commission discrepancy.

6.      So, let’s say you were interested in the “ultimate” solution using only withdrawals, which income, growth, and the recovery legs were guaranteed by traditional fixed annuities (and you used extremely conservative yields in the solution). An equation in A-Logic L&H software solution would produce an estimated “net income” after taxes of $141,327 (over 22 years) and recover your original investment principal back of $100,000 (in 22 years) with no annual fee and no market risk to the original investment principal. The solution could be liquidated 100% (minus any surrender change if any) in an emergency. You invest $100,000 and get $141,327 net with an additional $100,000 recovery. That’s a deal!

7.      The insurance company calls the GMWBFL benefit a withdrawal, which can be withdrawn at any time. But what they don’t tell you is any withdrawal greater than 5% (as example)…you will lose your lifetime guaranteed annual withdrawal benefit, and you will get the balance of your account value (which may have lost money over the years) minus your previous year’s withdrawals & fees.  

8.      If you take a withdrawal before age 59.5, the annuitant will not receive payments for life, but will receive only the original investment back, provided that the annuitant does not exceed the maximum withdrawal limitation, which usually 5%) minus any fees.

9.      As with GMWB benefit, the GMWBFL benefit forces you into an asset allocation model which is controlled by the insurance company (which 40% is allocated into the insurance company’s bond fund).

10.  Some (not all) GMWBFL benefits offer a “step-up” feature. Meaning if the account value is greater than your original starting value, the GMWBFL annual income will be recalculated. Unfortunately variable annuity sub-account performance is very “lack luster”… so hoping to make more income from your GMWBFL benefit could be a “fantasy.” Also there may be an additional fee for the “step-up” provision, or may have language in the prospectus which allows the insurance company to raise fees for the GMWBFL has high as 1.50%.

11.  GMWBFL cannot be purchased with qualified assets…since it may very well not meet RMD.

In the author’s opinion (conjecture only), the author believes that “living benefits” are a “misrepresentation” of risk, obviously created to increase assets for the insurance company, but also to increase the annual fees & fines to the NASD.

By not segregating investment components within the product…it leads to the misuse of the word “guarantee” and creates an illusion that the investor has no risk. The word guarantee is misused (without prejudice) in presentations and leads to complaints. Securities and non-securities must be segregated to avoid this problem. But when guarantees & risks are in the same package (under the same name)… leads to thousands upon thousands of complaints by consumers. Who suffers...the salesman and the public?

Taxes:

1. You cannot take a capital gains loss, but you can take a miscellaneous deduction, subject to the 2% AGI limitation ceiling which may be hard to meet.
2. No long-term capital gains and no step-up in basis at death.
3. RMD is calculated based on the account value plus actuarial interest benefits (living benefit guarantees). Versus a mutual fund which is based solely on account value. Basically increasing your distribution taxation.
4. It appears (and interpretation may differ) in Publication 939 of the IRS code, that the variable annuity payments which have been annuitizied, are adjusted for the “future” refund feature found in the “living benefits” of the variable annuity to compute the “correct” exclusion ratio (the tax free return of principal) for the taxes owed on line 16b of the 1040. This may increase the taxes of the annuitant versus if the annuitant annuitizied with a traditional fixed annuity.
5. There may be a “special” premium tax on annuitization in your state.
6. Tax deferral is the one of the good things about variable annuities. Tax deferral is very good, if you have good health and have a “good shot” living longer than 15 years. If your portfolio annual return is averaging greater than 10% every year (for the last 3 years in a row), tax deferral may not be a good idea…since tax deferral is worth 2.5% to 5% per year (depending on your tax rate).
7. IRA’s are already tax deferred, so why would you want to invest in an IRA variable annuity (getting charged 2.3% to 4% per year)?

 Growth:

1.      Do to only having 20 to 60 sub-account choices to choose from in a variable annuity…you’re limiting your investment performance (compared to choosing specific mutual funds out of a database of thousands of funds for the best possible return).

2.      Actual performance on returns, from year-to-year can be very disappointing concerning variable annuities.

Income:

1.      Withdrawals greater than 10% are not possible in the surrender period…which may seriously restrict a middle class client from paying his or her monthly liabilities. In addition, an annuitant may be limited to withdrawal caps of 5% to 7% using a living benefit rider and may be subject to penalties for exceeding the withdrawal ceiling provision.

2.      Income is taxed at the current tax rate versus the long-term capital gains rate for a mutual fund (held longer than 1 year).

3.      You cannot have income produced from muni-bond portfolios…due to the variable annuity is tax deferred. You can have an IRA-Roth account in a variable annuity…but is subject to AGI limitations, and limitations to how much a contingent beneficiary may receive tax free.

4.      You must wait 12 months for the first withdrawal with a maximum deferral feature of 10 years to take a withdrawal (and receive a bonus) for the GMWB rider. No “true” liquidity feature.

Other:

1.      Bonuses given in the first year (with some variable annuities) can be taken away…unless you annuitize for a “life” annuitization option.

2.      There is no monthly statements with variable annuities…you can only receive a statement annually (on the anniversary date of the policy). In addition, the sub-accounts are shown in “units” to confuse the owner how his or her policy is actually performing. It is truly un-believable when you look at a variable annuity statement (annually).

3.      Most variable annuities have surrender charges of 4% to 10% that are declining to 0.00% over a 4 to 10 year time frame.

4.      It may take up to 60 to 90 days to liquidate a variable annuity…if you want to get rid of it. Variable annuity companies are very fast to take your money, and very slow to liquidate.

5.      If the variable annuity company goes under (conjecture only), because it cannot meet the liabilities (due to not charging enough for put options within the contracts), the insurance company way be sold and there may be a hold on all liquidations for 3 or 4 years. In addition, if anyone has annuitized before the “failure” occurs, that individual may lose approx. 25% of the monthly income per month (from the annuitized asset), since the insurance commission often practices selling the assets of the “defunct” insurance company for a 25% discount.

6.      There is a maximum investment ceiling for a variable annuity…due to risk.

7.      If you have been placed into a fixed account (due to a living benefit guarantee) and the account is moved to a sub-account…there may be a severe penalty.

8.      There may be a special fee for spouses deferring tax on death proceeds each year of .50% for 5 years.

9.      In addition, there is annual M&E charges, management charges, special contract charges, and on & on.

Well, that’s all I have time to write about concerning variable annuities.

Sincerely,

John Bagwell

The Truth About Financial Products.com

www.thetruthaboutfinancialproducts.com