Should You Buy an Investment-Only Variable Annuity?

Should you buy an investment-only variable annuity? Investment-only variable annuities (IOVAs) are the new "hot product" being promoted by insurance companies, as sales of variable annuities (VAs) with income riders stall. According to Morningstar VA, sales in 2015 were $130.4 billion, a 5.5% decline from sales of $137.9 billion in 2014. 

Since their introduction in the 1950s, the design and features offered in VAs have continued to change in response to income tax rates and investment cycles. The primary attraction of a VA is the opportunity for tax-deferred growth. The owner of a VA can allocate money into a fixed account and/or selection of mutual fund subaccounts. The owner then has the ability to reallocate the money, subject to some trading restrictions, within the VA without any immediate tax consequences. In addition, as an insurance product, a traditional VA includes a death benefit that is funded through a mortality and expense fee (M&E).

In the 1990s, to remain competitive insurers began offering, at an additional charge, various riders that provided contract owners a future guaranteed income. These riders became very popular, and since the financial crisis in 2008, most VAs sold have included an income rider. To help back up the guarantees, insurers use a variety of financial strategies, including derivatives. However, with financial reform under the Dodd-Frank Act and falling interest rates, insurance companies have come under increasing pressure to trim back guaranteed income products, and as an alternative have been rolling out investment-only variable annuities (IOVAs). (See also: Living and Death Benefit Riders: How do they work?)

Like any VA, an IOVA provides tax-deferred growth. In addition, an IOVA:

• Has lower fees, since there is no death benefit. The mortality expense often exceeds 1% of the contract value each year in a traditional VA. However, the contract owner still incurs contract fees, as well as any management fees levied by the mutual funds selected in the contract.
  
• Offers contracts with surrender schedules as short as one year. However, some fees may be higher in contracts that offer the shorter surrender schedules.
  
• A wide range of investment choices that include many alternative asset classes, such as managed futures and long/short funds. Also, many insurers promote access to investment management companies that would otherwise require a much larger minimum investment.
  
• Fewer restrictions on allocation changes within the contract. Many VAs that include a guaranteed income rider also limit investment choices to a handful of asset allocation portfolios. These contracts may also restrict or limit the contract owner’s ability to move funds in and out of the different portfolios.
  

Distributions from any deferred annuity are taxed in a specific order. Earnings, which are taxed as ordinary income, are distributed first, followed by the tax-free return of principal. The exception is if the contract is annuitized, in which case each payment is a combination of principal and earnings.

To take advantage of the tax-deferred growth, an IOVA is a great place to own income-producing investments, such as a bond, REIT, or dividend-oriented equity mutual fund. Also, mutual funds with high turnover that generate a lot of taxable gains belong in an IOVA. Tax-efficient investments, such as municipal bonds or index funds, should be owned in a taxable account. Unlike a deferred annuity, a taxable account allows the investor to realize losses, which can be used to offset other gains and/or selectively sell positions with long-term capital gains. Unused losses can be carried forward to future tax years, and for many investors long-term capital gain tax rates may actually be lower than their ordinary income tax rate. (See also: How a Variable Annuity Works After Retirement.)

An IOVA is best suited for taxable investments. With no death benefit or income riders, there is really no benefit to investing IRA money. Investors considering an IOVA should:

• Plan to invest the money for at least 3-5 years.
  
• Have already contributed the maximum to any qualified plan or IRA (including a non-deductible IRA) for which they or their spouse are eligible.
  
• Currently be in one of the higher federal income tax brackets and expect to remain in a relatively high income tax bracket while working.
  
• Expect to be in a high tax bracket when retired. Otherwise, taxable annuity distributions could result in higher taxes on their Social Security benefit and Medicare premium.
  
• Think about when they will need the money, since there is a 10% penalty for distributions before age 59 ½ unless the contract is annuitized.
  

IOVAs take away some of the major criticisms of VAs: high fees and long surrender schedules. However, before buying a deferred annuity, investors really need to understand the tax issues and have a plan for how and when to take distributions. Otherwise, they may find themselves paying higher taxes in retirement when they no longer have deductions, such as qualified plan contributions and health savings accounts.