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Variable Annuities – Love Them or Loathe Them

Fixed income annuity contracts have gained popularity with conservative investors as a safe means of growing their money on a tax-deferred basis.  In the bull markets of the ’80s, a new type of annuity contract allowed investors to participate in the debt and equity markets and enjoy the benefits of annuities at the same time. These vehicles are known as variable annuities because of the variability of the returns realized.  Not many investments have a love/hate relationship from both investors and financial professionals as variable annuities.  Let’s explore why there is controversy with these vehicles.
An immediate annuity is where you exchange your lump sum of money for an income stream paid out to you for as long as you.  With a deferred annuity, your money either earns interest (fixed) or is invested in mutual fund-like sub-accounts (variable annuity) until you either withdraw it or annuitize it (described below).   There are only two ways to receive a lifetime income stream using annuities; annuitization and drawdown.
Annuitization – This is the original design for receiving lifetime income payments from an annuity. You hand the insurance company a lump sum of the money and the insurance company pays you a monthly stream of income for the rest of your life.  The size of that monthly stream is based on how big the lump sum you give the insurance company, your age, and what the interest rates are at the time you annuitize.   If you choose to annuitize, you may want to consider structuring the  policy as “Life with Installment Refund” or “Life with Cash Refund” so that you guarantee a lifetime income stream, but also guarantee that 100% of your money will go to your listed beneficiaries if you die early in the contract. Below are some of the positive and negative points to consider when it comes to annuitization.
Drawdown – This strategy is used when you attach an income rider to a deferred annuity contract like a variable annuity or a fixed-indexed annuity.  Income riders should be used for income planning at a specific date down the road, or target date. Drawdown really means subtraction, so when you start receiving your lifetime income payments, that amount is subtracted from your contract totals.
Positives

  • Flexibility — Income riders allow you to start and stop your lifetime income stream, and you can also change your initially planned start date if desired.
  • Target Date Planning — Drawdown strategies using income riders work best when you need your lifetime payments to start two years or more in the future.
  • Hybrid Benefits — Deferred annuities with attached income riders can also have additional guarantees like death benefits, confinement care benefits, or growth strategies that allow you to possibly accomplish more than one goal with one annuity.

Negatives

  • Low actuarial payout — Income rider drawdowns always have a lower actuarial payout % than if you annuitized. Having the flexibility that an income rider provides equals a lower payout.
  • Rigid contract rules — This one is really scary. A vast majority of variable annuity policies with income riders have very strict rules about how to properly access the contract for lifetime income. With some, if you take out more than the policy allows, it completely destroys the contractual guarantees. There will be some true horror stories in the near future concerning this issue.
  • Rider growth can’t be taken lump sum — Income riders used for target date income planning sometimes have annual guaranteed growth rates as high as 6% to 8% during the deferral years. It’s important to know that this amount cannot be accessed in a lump sum and can only be taken in lifetime payments, and that annual growth % stops when you begin your payments.

Fees and Expenses – Along with the potential to make a lot of money, you’ll also deal with several fees and expenses on either an annual, quarterly, or monthly basis.

  • Contingent-Deferred Surrender Charges. Like fixed and indexed annuities, variable annuities usually have a declining sales charge schedule that reaches zero after several years. You may have to pay an 8% penalty to liquidate the contract in the first year, a 7% penalty the next year, and so on until the schedule expires.
  • Contract Maintenance Fee. To (presumably) cover the administrative and record keeping costs of the contract, this fee typically ranges from $25 to $100 per year, although it is often waived for larger contracts, such as those worth at least $100,000.
  • Mortality and Expense Fees. These cover many other expenses incurred by the insurer, such as marketing and commissions. This fee can run anywhere from 1% to 1.5% per year; the industry average is about 1.15%.
  • Cost of Riders. Most variable annuity contracts offer several different types of living and death benefit riders that you can purchase inside the contract. These riders provide some additional guarantees, but each rider usually costs 1% to 2% of the contract value.

Taxes – Fixed, indexed, and variable annuities all get taxed the same way. Any growth in the contract is taxable, and getting your principal back is not. Each payment will reflect the ratio of growth to principal on your contract. If you doubled your money, then half of each disbursement will be taxable. For example, if a distribution is taken from a $300,000 contract for which $150,000 was originally contributed, then the ratio of principal to gain is 50/50. Therefore, half of each distribution is counted as a tax-free return of principal. And don’t forget, as with most other plans, any money you withdraw before you’re 59.5 is subject to a 10% early withdrawal penalty from the IRS.
Variable annuities can provide great returns, but they’re the riskiest type of annuity contract you can buy. Unlike fixed and equity indexed annuities, variable annuities do not guarantee your principal investment, interest, or other gains.
Only after you truly understand your own situation can you honestly evaluate variable annuities as a suitable investment alternative for you. It’s also important to know that the universe of variable annuity products is vast, and that their features and expenses vary widely, so it would be difficult to form a judgment based on any one product.

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