As financial planners, we are constantly asked this question by folks nearing retirement: “You always preach the importance of building a portfolio that pays income in retirement. So, what about a variable annuity? I buy it now and it guarantees me a steady stream of income in retirement, right?”
Wellll... Yes, we are big advocates of investments that will pay you consistently once your working days are done. But, we are not convinced that a variable annuity is the best tool for that job.
An annuity is a product sold by insurance companies that is designed to invest money from an individual and then pay out a stream of income to that investor over a multi year period of time. A variable annuity promises a minimum return from an “income perspective” plus the possible of a larger income stream based on how well the annuity’s investments do over time.
Understand each of these 7 items before buying a variable annuity:
1. “Real vs. Theoretical”- Never forget that most variable annuities consist of two pools, or “buckets” of money – one “real” and one “theoretical.” The “real” pool of money is what you as an investor place in mutual funds (called sub-accounts) within the variable annuity. You can withdraw this entire pool of money at any time – minus, often times, a surrender charge. The “theoretical” pool of money is your initial investment amount that grows at a predetermined “rate” set by the insurance/annuity company–for many annuities today that rate is 5% per year. Sounds great right? But here’s the catch...you don’t have FULL ACCESS to the value of theoretical bucket. The “theoretical” bucket is there for you to take an income stream from at some point in the future.
2. Who’s Backing these predetermined rates? Annuities are not insured or guaranteed by the government.
3. Surrender Charges -Annuity surrender charges can be significant – often between 10 and 2 percent and can be imposed as long as 10 years after you buy the annuity.
4. The fees are brutal - The annual non-sales fees on annuities average 3-3.5% and typically include charges for “mortality and expense,” administration, and investment management.
5. Commissions - Sales commissions can range from 4% to 8% - a significant incentive for those selling annuities.
6. Getting back your own money? Be wary of annuities that promise things like “guaranteed 5 percent income”. Annuities with long surrender periods and/or high annual fees lock-up YOUR money for long periods of time and then slowly pay it back to you. Remember, you can receive an “income stream” equal to 5 percent per year by simply withdrawing your “own money” for 20 years before it would run out, even if your money earned a zero percent return. (100% divided by 20 years = 5% per year)
7. Baby Boomer Stampede – I wonder about what would happen if the baby boomer generation needed to “collect” on the “theoretical bucket” guarantee all at once...either no one will need it because the market does very well over the next 10 to 20 years, or everyone’s going to need it (because the market did poorly). If we face the latter, how are the annuity companies going to handle this stampede of baby boomers that all need to “collect” on the annuity company’s promise around the same time? Anyone remember AIG?
So in my opinion, the benefits of a variable annuity generally don’t justify the high annual fees and long surrender penalties. But, annuities might make sense for some people in certain situations. If you are panic-prone, the protection offered by the “theoretical” bucket in a variable annuity may work for you, and help you avoid making bad investment timing decisions.
I just want to make sure you are asking the right questions before you buy and annuity and make sure you’re getting an objective opinion before you do so! Talk to a financial advisor – not just an annuity salesman. Remember; never ask a butcher if you should eat meat for dinner.