Boatman: Sorting out the complexities of variable annuities
One of the most confusing investments that many people own is a variable annuity (VA).
These products have many moving parts and riders. Many investors do not understand how much some of these options are costing them. Insurance companies are leaving this business or putting many more restrictions on the policy owners. All of these changes are starting to draw the attention of the regulators.
Variable annuities are very different from the fixed annuities that most people are familiar with. In a fixed annuity your premiums become a part of the company's general fund that contains billions of dollars. The full faith and credit of the company is behind them along with the security of the state guarantee funds. There is no stock market risk.
A variable annuity has a separate account that only contains your funds. It can be subject to market risk. You choose from a menu of available investment options. You pay a separate fee for each option plus fees to the insurance company. With a fixed annuity the investment performance is the responsibility of the company much like defined benefit retirement accounts. A variable puts the investment performance in the individual hands, much like a 401(k).
During the last couple of years, Genworth, ING, Sun Life, the Hartford and John Hancock have all quit issuing new VAs. Investors have fewer options than they did a few years ago. Some companies have quit accepting 1035 exchanges from other policies or new money from current policy owners. They never used to do this, but are now strictly interpreting provisions in their prospectus. They are also raising fees and making only more conservative investment options available.
The companies are feeling the pressure of low interest rates and increased option costs. Aggressive investment option was one of the draws to these investments. Some VA companies are offering buy-backs of some of the contracts. They are offering to increase value for a reduction in certain riders. Guess who comes out ahead in these transactions?
A few companies are starting to offer a new hybrid annuity. Structured Capital Strategies is one of this new type. They are somewhat similar to fixed index annuities but have two major differences. First, you can lose money in them unlike a fixed index annuity. Second, there is no guaranteed income rider, which is one of the biggest selling points of both FIA and VAs. Guaranteed income riders can be very important for part of your portfolio to make sure you do not run out of money during your lifetime. These hybrids have limited death benefit coverage. Some FIA have a very attractive benefit enhancer if the funds will not be needed by the senior and will ultimately be passed on to the next generation. Supposedly these hybrids are for accumulation but there are limits that cap potential gain. It will be interesting to see which niche these will benefit over time.
It is good that the companies are not trying to serve the guaranteed income for life segment, because a good fixed product can almost always beat a variable in this area. The reason is simple. All insurance companies are good at predicting life expectations. If they weren't, they would be out of business. A VA must also insure against stock market risk. As we saw in 2008, this can be very expensive. Because of this, they must pay out a lower return or they will be out of business.
The impact of these fees can be substantial. A case I recently saw had a client who had invested $98,000 in a VA 11 years ago. It had had a current value of $92,000 and a death benefit of $113,000. The client was able to change annuities and pay for a life insurance policy for the client's spouse with after-tax funds for $145,000.
They would still have the value in the annuity so the beneficiary would receive most of the $92,000 annuity value plus the insurance benefit tax-free instead of just $113,000 taxable. This is a net gain of more than double without taking any additional money out of the consumer's pocket. When the original broker asked the client why they were making the change, they were told the net gain for 11 years of the investment was a loss of $6,000. The broker said that this was not true because they had been deducting $432 per month for the death benefit.
This may have been the most expensive insurance policy ever written if you could get $92,000 out of your policy and you did not even have to die to get it or your beneficiary could receive $113,000 at your death; that is a net increase of $21,000. That is the amount of the insurance benefit. Someone this age could acquire $175,000 for the $432 per month. They would also get on top of this the remaining value in the annuity, which they don't get in the VA. The life insurance is tax-free but the VA benefit is not, since this is a qualified annuity. To make matters worse, the client had been paying these fees for years and did not even realize it.
This is a very common occurrence with VAs. If you own one, maybe you should get an independent review from someone other than the person who sold it to you. There are extensive suitability standards that must be met before making any change.
Gary Boatman is a certified financial planner and local businessman who serves as president of the Monessen Chamber of Commerce.