Introduction to Annuities: Variable Annuities

In the last section, we examined indexed annuities and their components. In this section, we will examine the third major category of annuities. Traditionally, variable annuity investors have been subject to the same market risks as investors of taxable stock and bond funds. In recent years many different features have become available within variable contracts that have reduced – or, in some cases, even eliminated – this risk.

Mechanics of Variable Annuities

Variable annuities are the most complex type of annuity in the market today. In fact, they are one of the most complex investments in existence, probably second only to variable universal life insurance. In a nutshell, these contracts consist of a bundled offering of mutual fund subaccounts that grow under a tax-deferred umbrella. The groups of subaccounts offered and the specific annuity products that they are in will vary according to the agreements made between the fund families and insurance companies. Most of their complexity resides in the various riders and other benefits that are commonly offered in modern contracts.

Protections

These riders are aimed at reducing market risk through various means. For example, many variable annuities offer a rebalancing feature, where the initial asset allocation among the various funds offered within the contract is preserved by automatically reallocating the growth of each fund from the higher-yielding funds to the lower performing ones. Over time, this can be an extremely effective method of profiting from normal market cycles among various sectors. Dollar-cost averaging (DCA) programs are another method of increasing return while decreasing risk. Many companies will offer a high guaranteed rate of interest in a fixed account for a short period of time, such as six months or a year. The contract proceeds are initially invested in this fixed account and then moved into a preselected allocation of funds in equal shares over the prescribed period of time.

Many companies have gone even further in providing their clients with peace of mind while investing in the market. There are now riders available inside many of the contracts offered by major carriers that will guarantee not only the investor's principal, but also a set rate of growth. Furthermore, if the underlying funds outperform this rate, then the investor can reap the difference in growth between the two as well. However, this guarantee comes at a price, which will be examined more closely in an upcoming example.

The investor is not the only party privy to security features within the contract. If the annuitant dies, most beneficiaries in modern contracts will receive the highest of the current contract value, the highest anniversary value or a hypothetical amount based upon a fixed interest rate if the current value of the contract is less than that. Any withdrawals that the annuitant received are, of course, subtracted from the calculation of these amounts.

Fees

The various features that variable annuities offer come with corresponding charges that must be deducted from the contract value, either on an annual or quarterly basis. These fees cover a number of expenses, and can be broken down as follows:

Mortality and Expense Charges – These are standard base fees found in all variable annuities. These fees cover the death benefit provisions commonly found in most contracts.

Contingent Deferred Sales Charge – This is a back-end charge that declines to zero over time, usually by 1% per year over five to 10 years. This charge provides a substantial deterrent to an investor seeking to withdraw funds from the contract until a reasonable period of time has elapsed. However, most contracts today offer a free withdrawal window of 10% per year, as well as total liquidity provisions for such things as nursing home expenses. If the contract owner is below age 59½, however, the 10% early withdrawal penalty assessed by the IRS still applies.

Administrative Service Charge – This charge covers the money management features discussed earlier, such as asset rebalancing and dollar-cost averaging, as well as confirmation and monthly statements.

Contract Maintenance Charge – This cost is usually $15–$50 and is for the general maintenance of the contract. It covers the cost of issuing the contract, along with general administrative costs.

Fund Expenses – These are fees charged by the mutual funds within the annuity contract that are passed to the contract owner. They include 12b-1 fees and other management-related fees.

It is clear that the various features offered within today's variable annuity contracts do not come for free. Normally, the average contract owner can expect to pay 2% to 3% per year in combined fees, which are deducted on either a quarterly or annual basis from the contract value. The number of riders that are chosen will determine the exact percentage that is assessed.

To better illustrate this concept, let's examine a hypothetical annuity contract where the investor chooses a normal array of riders and benefits.

Sam Sutton buys a $100,000 contract with a major insurance carrier. He decides to participate in the dollar-cost averaging special that pays 7% in the fixed account over a one-year period during which $12,500 is moved monthly into the allocation of funds that he has selected. He also opts for the 7% guaranteed minimum benefit rider, which guarantees that he will receive at least 7% growth over the life of the contract as long as he adheres to certain withdrawal provisions. Finally, he adds the asset-rebalancing feature as a growth and safety measure. Here is a breakdown of what these features will cost him:

This total is fairly high in terms of relative fee structure. For example, most professional money managers (meaning Registered Investment Advisers, who trade individual securities directly for clients) charge less than this (often less than half this amount, in fact) per year.

Based upon the charges that are listed here, it would seem prudent to invest the proceeds of a variable contract aggressively, especially if a guaranteed minimum income benefit rider is used. After all, if the contract is charging 3% a year in fees, and the rider guarantees a minimum rate of growth of 7%, then it would make sense to invest the principal in the contract in technology or small-cap funds that have historically yielded 10%–12% growth per year. Unfortunately, most variable carriers place limitations on the allocation of contract proceeds to match the rate of growth offered by the rider, so that there is little chance that the actual cash value in the contract will exceed the amount guaranteed by the rider.

Investors should carefully weigh the income withdrawal provision against their income needs during the payout phase. Guaranteed income riders often require annuitization, which irrevocably locks the contract into a set payment schedule that cannot be altered. This means that if the investor's income needs change after payout begins, he or she cannot alter the income from the annuity to accommodate those needs. Therefore, guaranteed income riders need to be considered carefully from several angles by an investor before being chosen.

It should be noted that some insurance carriers are now starting to offer unbundled benefits within contracts, thus allowing investors to choose the riders and benefits that they think they will need and not be forced to pay for other provisions that they think are unnecessary.

Use of Variable Annuities in Retirement Plans

This issue deserves special attention for two main reasons. First, a substantial percentage of all retirement plans, qualified or otherwise, are invested in annuity contracts. Second, there is some controversy about whether annuities belong within a tax-deferred retirement plan to begin with.

Many retirement planners and insurance advisors use annuities as the de facto investment vehicle for funding any type of retirement plan, regardless of whether it is group or individual, qualified or nonqualified. Virtually all 403(b) plans are invested in Tax Sheltered Annuities. But what is to be gained by doing this? Annuities are inherently tax-deferred by nature, just as retirement plans and accounts are. There is no such thing as double tax-deferral! So why is this practice so common?

This question has more than one answer. The response usually given by the insurance industry is that annuities offer many other features and benefits besides tax-deferral, such as money management features and insurance protection. This latter feature has been substantially developed over the last five years via the guaranteed contract riders discussed earlier. Admittedly, these options do allow for a guaranteed stream of retirement income that conventional retirement plans and accounts alone cannot duplicate. But they come with a cost that must be borne by all participants, not just those whose need for income happens to fit the guaranteed option riders offered within the annuity contract.

It is important to note that inside a retirement plan – when all possible investment choices are offered within a variable annuity – all plan participants are forced to pay the commensurate contract fees. Many participants do not need or want a guarantee of principal. While it is of course possible to waive many of the protection riders, there are certain mortality and expense fees that cannot be avoided. As stated previously, these fees effectively reduce the overall return that participants will realize from their plans over time.

Furthermore, most plan participants do not understand enough about the plans they participate in to separate the plan from the annuity contract or the investment. Most advisors will simply tell participants that they are investing in mutual funds. They are, of course, but within the variable annuity contract that the plan has been placed in. In reality, a large percentage of plan participants do not even know that their retirement plan is contained within an annuity contract at all, and think that the fees and expenses are just part of the plan's administration costs.

Note that both the SEC and FINRA take a dim view of annuities within tax-deferred accounts. In 2012 FINRA issued the following notice to investors: "Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson."  The SEC issued a similar warning in 2011.

For more information on this topic, see Are You Buying Annuities or Mutual Funds?