Some conversations about investing make no sense like the argument that variable annuities are great (made by those who sell them) or terrible (made by those that hate any product with fees, e.g. the Wall Street Journal). A variable annuity, like a corporation, is a type of entity. You would never argue that corporations are “good” or “bad” and you cannot argue that VAs are good or bad. They are however appropriate and inappropriate in various situations. And they have too often been sold inappropriately by someone who did not know better (many people with traditional life insurance backgrounds have poor investment understanding) or simply sold the product to gain a commission. Let’s pull back the covers.
Typically, the proponents of the product argue the benefits
? Tax deferral
? The death benefit
? Riders such as guaranteed income benefits
Opponents argue that
? Mutual funds are betters because withdrawals from VAs are taxed as ordinary income
? The death benefit is of little value (how many people make an investment with the intention to die?)
? The guaranteed income riders may not be worth it
As to the issue comparing VAs to mutual funds, the “winner” will be a function of the
? investor’s age,
? his current and future tax bracket,
? the type of fund and sub-account being compared,
? the investments fees in each and
? the amount of switching among funds done by the investor
For example, if one were to hold aggressive growth funds which typically have turnover rates exceeding 100%, much of the gains will be short-term and taxed as ordinary income—no better than the tax on VA withdrawals. So the argument that the taxation of VAs is worse than funds is not always true. And the taxation is only one of the five variables that need to be considered.
Age is another issue and this is where VAs likely get a bad reputation. In any tax deferred vehicle, the tax deferral has the greatest benefit the longer the tax deferral period. Therefore, older people cannot benefit much from the tax deferral and the sale of VAs to seniors is questionable. Of course, there’s always the exceptional grandpa who says “I want to leave this $100,000 to my grandchildren. Let’s put it in a VA in the most aggressive fund. If it doubles, then great, my grandkids win. If it tanks, then they still get the $100,000 death benefit.” In general however, VAs are more suitable for younger, not older investors, as younger investors get more benefit from longer deferral.
Start with $100,000
Taxable at 5% Tax Deferred at 5%
Year 5 $117,910 $127,628
Year 10 $139,029 $162,889
Year 15 $163,930 $207,893
Year 20 $193,290 $265,330
This table shows that the difference between a tax deferred and taxable balance grows with the deferral period making any tax deferred investment most appropriate for younger people.
The death benefit is of highly questionable value. On a mathematical basis, we could show in most cases that the amount charged for the death benefit is not worth it. While the death benefit is clearly comforting to many people, it isn't worth anywhere near the price most insurance companies charge their customers for it, according to a study by Moshe Arye Milevsky of Canada's York University and Steven Posner of Goldman Sachs. They found that consumers are being charged as much as 5 to 10 times the economic value of the guarantee for a basic return-of-premium variable annuity. Indeed, once the steep variable-annuity fees are taken into account, most long-term investors would do much better putting their money into a low-fee equity index mutual fund or a tax-managed mutual fund. Their bottom line: Most insurance companies are charging their customers too high a price.
Similarly, new riders that provide minimum lifetime income payments or a guaranteed return may not be of economic value. Basically, if you are young, the payment for these rider guarantees is a raw deal. But they do have economic value if you are older and make more aggressive investment selections. In the case of both the death benefit and minimum income benefits, the big question is how the individual buyer values these. Since people do not make logical or rationale decisions, the economic value of these guarantees appear to be far less important than how important the feature “feels.” That’s the difference between a financial advisor and an economist. Good fincnial advisors attempt to give good technical advice and good emotional advice. They actually talk to and care for the people they serve and realize that they buy emotionally.
This issue of serving investors emotional needs cannot be overlooked and because it is, often causes a fruitless conversation about VA pros and cons. The accountant argues that the tax benefits of VAs are poor and the advisor, rather than to argue this point, would do well to agree with the assertion. But the advisor need further explain that his clients would sit with their money in a 2% money market had it not been for the comfort provided by the VA minimum income guarantee that was not available in another instrument (some VAs now provide a rider offering a 5% minimum return if held for 10 years). In other words, as advisors, the task is to improve the client’s situation even if the client won’t do what’s optimal. Accountants, economists and academics often seem to take the position that of the solution is not the best solution, it’s bad.
In general, VAs will be most suitable for growth oriented younger investors. Advisors would do well to offer those with low fees to the investor and sacrifice commission. (Many options with super low cost structures are available now, typically offered by fee-based planners). The only significant objection that a young buyer would have is the penalty for withdrawal prior to age 59 ½. Consequently, VAs should be sold as a long term retirement saving tool that may eventually provide a lifetime income and contribute to a sustainable retirement. It’s only when VAs are mis-sold for the wrong reasons, to the wrong buyers and sellers attempt to defend indefensible features (e.g. the economic value of guarantees), that VAs and their sellers get egg on their face.
