I have interviewed six potential new clients in the past few weeks. All were similar cases in that they were approaching retirement and had recently experienced some employment related change. All six were in a position where some sort of decision had to be made regarding the disposition of an employer sponsored retirement plan (401(k)). All six came to us with sales materials in their hands for variable annuities. Four of the six went first to their respective banks for advice about what to do with their retirement plans, variable annuities were recommended to all four. We find that variable annuities are rarely a good solution for any client, especially for IRA rollovers. If you are in this position and are being offered a variable annuity, we would ask that you consider the following:
The variable annuity may be the most consumer adverse financial product ever devised. A variable annuity (VA) is a collection of mutual funds inside an annuity wrapper; the annuity wrapper serves as a tax deferral shell. In return for allowing the tax deferral shell, congress decreed that insurance companies must provide some type of actual insurance. In most VA contracts this takes the form of: “If you die while the contract is in force we will pay you at least what you put into it”. People who selll these things point out “Isn’t that great, you can’t lose money here”. Keep in mind that that’s not what the guarantee says. What the guarantees says is “you can’t lose money if you die before you need it”. Talk about a severe penalty for early withdrawal. Of course there is a charge for this insurance. Morningstar recently published current data on the top 50 Variable annuity contracts (by sales volume). Contract charges (mortality insurance + administrative fees) averaged 1.36%. Now keep in mind that these VA contracts are being sold as rollover IRA vehicles. They question is, why would you purchase a tax deferral shell (the VA) and pay 1.36% annually of your hard earned money when the U.S. Government already provides you with a tax deferral shell for free (a rollover IRA)? If you are being sold on the virtues of a variable annuity for a rollover IRA consider also the very long surrender charges associated with these contracts which can last as long as 10-15 years and be as high as 10 to 15% of the amount you invested.
“But…”, the annuity salespeople say, “we have other great guarantees built into our product”. These additional guarantees are called “living benefits”. Usually the pitch goes something like this: "We're going to guarantee you that no matter what how bad your investments perform, we will guarantee you X percent when you retire". Sounds great until you read the fine print which informs you that the only way you can get that guarantee is if you will agree to let the insurance company pay you a guaranteed income for life. That means that you really don't have access to your principal. Also, unless you agree to take even less income, when you die there is nothing left. So, if you want this guarantee, and you agree to the annuitization and die shortly thereafter, the insurance company wins their bet, takes all of your money and your family gets nothing. You better believe that insurance companies are very good at making these bets, they have been doing it very profitably for hundreds of years.
In addition to the distasteful nature of this bet, insurance companies are building in a guaranteed profit by fixing the terms of the annuitization. Typically the payout is a fixed percentage of the value of the variable annuity on the date the annuity payout begins. Keep in mind that, because at death there is nothing left, the payment consist of both principal and interest, it is not all income. Fortunately there is a way to determine the exact value of this income stream. All you have to do is obtain a quote for immediate annuity from a few insurance companies. You can purchase these at any time from any life insurance Company. Since the only way that you can obtain the accumulation guarantee is by accepting the annuitization, the cost of the annuitization gives you an accurate idea of what the accumulation guarantee is actually worth.
Moshe Milevsky, a professor of finance at the Schulich School of Business at York University in Toronto published an article in the August 2009 issue of the Journal of Annuity Analytics http://www.ifid.ca/pdf_newsletters/AUGUST2009RESEARCH.pdf . In this article Dr. Milevsky calculates what the guaranteed accumulation rates in variable annuity contracts are actually worth based on immediate annuity quotes obtained in March of 2009. The calculations are fairly simple on a business calculator with a present value function. He simply takes the market cost of providing the guaranteed annuity payments and figures out what rate is required to get to that lump sum from what you put into the contract originally. For instance, if you purchased, at age 55, a variable annuity with a guaranteed lifetime income benefit with guaranteed growth of 5% during the accumulation phase and that promised a 5% pay out factor for life (beginning at age 65) the effective rate of return would have been 0.18%! In the Morningstar data mentioned above, the average range of fees for living benefits was 0.65 to 1.09%. These fees are in addition to the contract fees above. Another way to look at the nature of this guarantee is that the insurance company is saying “if you would like to us to guarantee that you won't lose money, give it to us and we’ll dole it back to you over your lifetime but not pay you anything for the use of it. In the meantime (20 to 40 years) we get to invest it and pocket all the earnings. For this service we will charge you between .65% and 1.09% on average. This is why insurance companies can afford to occupy such nice large buildings.
Finally, since variable annuities are mutual funds inside an annuity wrapper, you still have to pay fund management fees to the companies that mange the mutual funds or separate accounts within the variable annuity. According to Morningstar (average of 27,434 funds) these fees averaged 1.32%. To recap then, total fees in the top 50 best selling variable annuities averaged 3.8%. When you consider the low-return environment we are faced with, this is a staggering burden. Conservative investors who stick to fixed accounts, money markets, or conservative bond funds within a variable annuity may, in fact, produce negative returns after fees are considered.
So, why are variable annuities pushed so hard by commissioned brokers, particularly bank brokerage subsidiaries? Consider that the average upfront commission on the top 50 best sellers in the Morningstar variable annuity study was 7.19% while the average commission on all mutual funds with upfront sales charges (4,099 funds) was 4.79%. That’s a 50% higher payout to the broker in return for selling a variable annuity into a rollover situation rather than a IRA with loaded mutual funds. Remember that the brokerage business is and has always been about generating commissions, it has never been about doing the best by your client. All brokers are legally obligated to do is see that the products they sell are suitable for given investors risk profile, not that they are the best or most cost efficient product or account structure for that client. Meanwhile, numerous articles in the financial press chronicle lamentations from insurers that variable annuities do not enjoy widespread support from fee only investment advisors. Perhaps when you have a fiduciary obligation to seek the best solutions for your clients the variable annuity falls woefully short in all but very limited circumstances