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Tony Novak, CPA, MBA, MT
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Today’s variable annuities
by Tony Novak, CPA, MBA, MT
, revised 11/28/2011
Annuities are insured investment savings accounts used to build and manage retirement income. In the past the main attraction of this type of investment was the ability to save taxes. Under current law, taxes on retirement investments earnings are not a significant burden to most investors. Today, annuity accounts are most useful in combination with pension plans that require insured investments. Annuities make it easier for the pension plan manager to predict the future benefits and the IRS makes special allowances to these types of pension plans that reduce costs for the employer sponsoring the pension plan.
The word annuity is defined in the dictionary as “the annual payment of an allowance or income” but in today’s real-world usage, few of these accounts actually involve any fixed stream of income. Most owners only use the annuity as an accumulation account during their working years, and then make manual withdrawals or roll the annuity into an IRA at retirement.
The term “variable annuity” refers to the ability of the owner to choose from among a range of investment options that resemble mutual funds. The introduction of investments with variable investments into insured investment accounts with guaranteed results creates both complications and opportunities for investors.
Today’s variable annuities are significantly better than those available only few years ago and frequently a better choice than other investment options. These new variable annuities are also useful to retired investors who are concerned about protecting the value of their assets for the benefit of their spouse or beneficiaries. The specific account features vary with each individual investment product.
This article is meant to offer a generic summary of what you can expect from today’s best annuities in comparison to older more traditional annuities and mutual fund accounts.
Key to the table listing below:
█ Traditional variable annuity
█ Mutual funds
█ Modern no-load variable annuity
Traditional annuities used a single brand of investment managers, usually offering about a dozen choices in each account.
Mutual funds use a single brand of investment managers, usually offering about a dozen choices in each fund family.
Today’s best annuities combine dozens of choices from a wide range of investment managers from different name brand investment companies. It is not necessary to make an “up front” decision about what investment company you want to hire before selecting an annuity account since a multiple manager investment allocations are the norm in these accounts. This makes it is easier to diversify among different investment managers and investment styles within the overall framework of one single annuity account.
Investment Guarantees During the Lifetime of the Owner
Traditional annuities do not guarantee the value or investment performance of the account during the lifetime of the owner.
Mutual funds do not guarantee the value or investment performance of the account.
Today’s best annuities guarantee the principal over a specific period of time even if the markets lose value during that period. If the market loses value and the account value drops, the insurance company “makes up the difference” to the owner at the end of the period specified. A guarantee period is typically 7 to 10 years and may be modified by the account owner. This is one of the only ways to invest in stocks with an expectation of long term appreciation and still have a guarantee that you will not lose money over the next market cycle.
Investment Guarantees to Beneficiaries at the Death of the Owner
Traditional annuities guaranteed that the account would not lose money over the lifetime of the owner. If the account dropped in value, the insurer would “make up the difference” to the beneficiary. This is commonly known as a “guarantee of principal”.
Mutual funds do not offer any guarantee of principal or rate of return and may lose money.
Today’s best annuities guarantee the principal plus a minimum annual rate of return over the lifetime of the owner. If the account gains less than the minimum guaranteed rate, the insurer “makes up the difference” to the beneficiary. A typical minimum rate of return guarantee is 4% to 5% per year.
Traditional annuities do not include a life insurance option.
Mutual funds do not include a life insurance option.
Today’s best annuities contain an option to add life insurance at a small fixed charge even if the owner has health conditions that would be otherwise make it difficult or impossible to buy life insurance. The beneficiary receives the balance of the investment account plus an additional amount for the life insurance. This is an easy way to boost financial security for a surviving spouse. Assuming a $100,000 account for an investor aged 70, it is possible to add $40,000 term life insurance for an account charge for less than $400 per year. The cost rises in later years, but this no-load life insurance is still cheap compared to most other life insurance plans.
Traditional annuities penalize investors for early withdrawals during the first years after deposit.
Some mutual funds charge investors for early withdrawals, others do not.
Today’s best annuities do not include any surrender fees and allow free withdrawals at any time.
Most traditional annuities charge commissions.
Some mutual funds charge commissions or other charges called 12(b)(1) charges. A minority of mutual funds charge neither commissions nor 12(b)(1) charges.
Today’s best annuities are called non-load annuities and do not charge any commissions. It is not that commissions are necessarily a bad thing, but all other things being equal, a no-load annuity will return more money to the investor tan one that draws off some of the funds from the account to pay commissions.
Total Account Charges
Traditional annuities have total charge typically ranging from 1.25% to 2.5% more than mutual fund accounts, averaging about 2.0% per year over the lifetime of the account.
Most mutual funds have total charge typically ranging from 0.3% to 2.0%, averaging about 1.3% per year over the lifetime of the account.
Today’s best annuities have total charges ranging from 1.25% to 2.8% more than mutual fund accounts, averaging about 1.6% per year over the lifetime of the account. These fees are customized by each account owner so the actual cost is controlled by the options that the account owner chooses.
One interesting side note on the cost issue is that while the operating costs for variable annuities are significantly higher than mutual funds, a series of articles published in the 1990s showed that the net investment returns to account owners were virtually the same for variable annuity owners as mutual funds owners. These studies were made during strong bull markets. The reasons behind these results and the validity of interpreting these reports in today’s market climate is frequently questioned by investment advisers. In any case, there is no doubt that a variable annuity loaded with all of the insurance and investment options will cost significantly more than other investments.
By the date of this article revision in 2011, some investment companies had revised their products to address the limiting distinctions presented in this article. The result may be fewer distinct differences between asset classes but more complexity in the details of an investment product’s design and features.
Modern no-load variable annuity accounts tend to offer investors significant advantages over other investment options at an additional price. Each investor should evaluate the cost / benefit tradeoff in relation to their own values and priorities incorporated into their overall personal financial plan. Investors who choose higher net rates of return with higher market risks would likely prefer mutual funds. Investors who want more guarantees and are willing to accept a lower rate of return would likely prefer annuities.
This article presents a very brief and intentionally oversimplified view of the topics discussed. The features of annuities and mutual funds vary significantly between different investment products, even among accounts with very similar names. It is important to review the investment prospectus for the features and details that apply to any investment account.
All of these investments advise the prospective investor to seek professional advice with regard to the financial planning and tax implications as applied to your specific situation.
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