The Real Truth About Variable Annuities

"One of the most misunderstood investment strategies I've come across over the past 25 years is the variable annuity," writes Investment Adviser Representative Craig Kirsner in a recent column on Kiplinger.com. I agree with that statement. But not for the same reasons.

As a longtime insurance professional and former chief legal counsel for Charles Schwab, I’ve seen annuities bashed for many reasons — occasionally valid, but more often than not because they are just plain misunderstood.

Variable annuities have come a long way. Years ago it wasn’t unusual to see expensive, commission-laden products that sometimes made too-big promises. But that was then, this is now: Today’s variable annuities are leaner, meaner, more liquid, more cost effective and more transparent.

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So, it’s time to update consumers on their progress and debunk some of the bad old myths.

How They Do What They Do

Variable annuities are just one piece of the retirement puzzle. They work by allowing annuity owners to invest in mutual-fund-like subaccounts called Variable Insurance Trusts, while deferring taxes on the gains in those investments. Bear in mind that these investment options may share a name with their retail mutual fund counterparts, but are completely separate, and their performance, though similar, may differ.

What makes VAs valuable is that they extend tax deferral for folks who have maxed out other tax-deferred options, like 401(k)s and IRAs. That means investors aren't limited to the relatively low contribution limits of those plans, and may enjoy virtually unlimited tax deferral on the returns of these underlying investments, without being forced to take required minimum distributions.

Some of these next-generation variable annuities also offer additional insurance protections, alternatively referred to as living benefits, riders or guarantees. These protections may guarantee a return of principal to heirs, for example, or create an income stream in retirement without forcing annuitization (more on that in a bit).

Where these protections have been very expensive in the past, today's riders can range from 0.10% to 1.4%, depending on the level of protection. It’s important to know what problem you're solving, and to ensure that you aren't paying for something you don't want, or won't use.

It's also important to understand that variable annuities are just that: variable. They offer market exposure, and that means they can lose value — unlike their cousins, the fixed annuity and fixed indexed annuity.

Designed for Retirement

Some investment professionals tend to argue that because retirees need to protect their principal in retirement, variable annuities offering equity exposure are too risky. That simply isn't true. Not all VAs are appropriate in all situations, but they are appropriate in the right situation.

For example: For a person in the five years prior to or the five just after retiring, a variable annuity with income rider can protect them from sequence of returns risk. This 10-year period surrounding retirement is often called “the fragile decade,” because poor market returns in this period, when retirees begin taking withdrawals, can be difficult to make up down the road.

The mission, in this example, could be to prevent clients from outliving their retirement assets. The strategy could be to avoid sequence of returns risk in the fragile decade and the tactic could be to take a portion of assets (maybe non-qualified dollars that have accumulated in a variable annuity already) and invest them in a variable annuity with an income rider.

A Word About Fees

Execution will depend on finding a no-load VA with low fees. These annuities are sold without commission and come priced as low as 0.2% to 0.5% of the account value paid annually.

Because they aren't sold for commission, you may need to find a fiduciary to assist you, but many of these variable annuities are offered directly from the insurance companies. Some low-cost, no-load variable annuities (and their costs, below):

1. Ameritas Advisor No-Load Variable Annuity (0.45% mortality and expense fee — learn more on the Ameritas website)
2. Great-West Smart Track Advisor (0.2% M&E fee — learn more on the Great-West Financial website)
3. TIAA Intelligent Variable Annuity (0.25% to 0.5% — learn more on the TIAA-CREF website)
4. Transamerica Advisor's Edge (0.55% M&E — available through RetireOne)
5. Transamerica iShare (0.2% M&E — more information is available in its prosepctus)

Sure, you can pay a lot more. Those 4% variable annuities you may have heard about might still exist, but a new generation of no-load annuities built for fiduciaries is driving down costs and improving product value. Add in the underlying subaccount costs (comparable to retail mutual funds, by the way) and an income rider, and the total cost could be as low as 2.1% to 2.4%. Yes, insurance companies charge for this. Almost nothing is free, after all.

Even if you don't use the rider to produce income in that fragile decade, the amount of your income distributions will be based on either your initial investment, or the greater of your account value on prescribed anniversary dates.

Flexibility During Market Uncertainty

If markets go south, you can elect the income rider and have an insurance company create an income stream for life that will be paid out even AFTER the account value is completely liquidated. Or, if things go well, with some variable annuities you can simply elect to drop the income rider from the policy, stop paying those fees, and start taking withdrawals from the accumulated value. You then have more control.

You could also annuitize the variable annuity in retirement. Annuitization is basically what happens when you give an insurance company a lump sum of money, and they promise to pay a stream of income based on the number of years you intend to use that income stream (or for life). That's exactly what annuities were designed for — to provide a guaranteed income stream for folks in retirement, which makes them pretty suitable for retirees. Many economists think so, too.

Putting It All Together: An Example of How It Works

Let's say a 60 year-old investor with $1 million in assets wants to at least protect a portion of her portfolio from a market downturn. Right now, we appear to be nearing the end of a historic bull market. Vanguard and others are warning of a coming recession, though maybe not for a while.

Our investor is concerned about taking a hit in the first few years of retirement as she begins to take income. She has no pension, and her Social Security benefit promises to offer $30,000 a year. She wants to replace roughly 80% of her current $85,000 salary in retirement, so she'll need to generate an income stream from her $1 million nest egg equal to $38,000.

The traditional 4% withdrawal rate, if applied to her portfolio, could easily generate the difference. But if she were to lose 20% of her portfolio sometime in the next five years, she'd have to take $8,000 less in income annually.

Plus, when she begins drawing down her assets, if her portfolio doesn't return at least 4%, she's losing principal. This could be a bad setback for her whole retirement.

Instead, she could take $500,000 from her $1 million in assets, and invest in a variable annuity with an income rider that guaranteed an annual “benefit base” increase of 5% every year that she did NOT take income. All-in cost for the variable annuity could be 2.4%. If in the years leading up to her planned retirement age, the markets dropped and she lost 20% of her nest egg, she'd be left with $400,000 in her variable annuity and $400,000 remaining in her other account(s).

Keep in mind that she's only 60. She's fully employed and doesn't plan to take income for at least another five years. If in that five-year span markets lost 20%, her benefit base would have grown at least 5% every year. Yes, her account value would shrink by $100,000, but the number upon which her income payments are valued (the benefit base) will have increased to roughly $625,000.

At 65 her annual income, guaranteed by the insurance company's income rider at 5.5%, would be $34,000 for life. This would allow her to draw much less from the other account (2% or less) and allow that asset to potentially grow more as markets recover.

For a cost of 2.4% of her annuity account value, she will have insured her retirement income stream against market shocks that could negatively impact her lifestyle in retirement. And if she waits to take income for a couple more years, her annuity alone could meet her retirement income needs.

A note about 'benefit base' vs. 'contract or account value'

Benefit base, or withdrawal base, is a figure that has no real cash value. This is the insurance component to your investment. If your account loses value, your benefit or withdrawal base does not, so long as you do not take withdrawals. Many unscrupulous salespeople purposely conflate the benefit base with account value.

It is definitely not the same thing. Understand that even as your benefit base may grow, your account value (the lump sum that you could actually liquidate, if you chose,) may be depleted by a combination of market losses, withdrawals AND insurance charges. The real impact of this is on your legacy.

With that said, these riders guarantee income for life. In this case, that stream of income is guaranteed to be 5.5% of the benefit base, no matter what. What typically gets folks into hot water with these products is a misunderstanding of the difference between the account value, and the benefit base, and any underlying surrender penalties. None of the products above charges surrender penalties, so that's not an issue in this scenario.

Having said all of that, be sure to talk to your financial adviser before investing in a no-load variable annuity with an income rider. There are some nuances to understand, and they should only be considered in the context of your whole financial plan. Be sure to mention “no-load” variable annuities, by the way.

About Those 'Bad Actors'

Another argument that consumers may sometimes hear is that variable annuities are not good for retirees because of “bad actors,” not necessarily the variable annuities themselves. If an adviser mischaracterizes the riders you are buying or isn't disclosing all of the fees, and risks in all of your investments, that adviser isn't doing their job — and there are repercussions for that.

There are very strict rules around how VAs can be sold and marketed, and disclosures around the risk of loss of principal are not optional. These are insurance products, designed to insure against specific risks, but like all investments, other risks may remain.

Where Does This Leave Consumers?

The proper way to consider whether a variable annuity is appropriate for you is not to start with the variable annuity, but with your needs. In this way, a variable annuity isn't always right or wrong. A good adviser will consider cost, taxation, liquidity, your investing horizon and other things when choosing an investment like a variable annuity.

In the end, some of the arguments made against variable annuities — including the ones made by Mr. Kirsner’s column 7 Myths About Variable Annuities — amount to this misguided warning: Because of how they've been sold by some folks, variable annuities are all bad for retirees. Mr. Kirsner argues not against the inherent value of variable annuities, but the questionable ways in which they have sometimes been sold. In this, we are in complete agreement.