Variable Annuities Are Money Traps

AARP recently listed several money traps people fall into. One of the traps on their list is buying variable annuities. The details:

The cardinal rule of investing is, keep things simple, and variable annuities are anything but, melding the potential for growth that comes from stock investing with the guarantee of a steady income that all annuities are supposed to provide. Mixing motives costs you. The average annual expense fee for a variable annuity is 2.39 percent of assets, compared with the average mutual fund expense fee of 1.36 percent.

Need we say more? We could, because that number doesn’t even include sales commissions or surrender charges applied if you pull your money out years later. And the fund monitor Morningstar reports that the average variable annuity underperformed the average mutual fund no matter what time span it examined—one year, three years, five years, or ten years. For the past ten years the average variable annuity invested in stocks posted an annual return of 6.72 percent, compared with the average fund return of 8.71 percent.

A few thoughts here:

1. Variable annuities are often very complicated and difficult to understand. Many make it hard to know what you're really earning. Strike one.

2. Variable annuities are expensive. 2.39% of assets is a FORTUNE -- especially when you could pay 0.20% with an index fund. Remember, costs make a tremendous impact on the performance of an investment and variable annuities simply cost too much. Strike two.

3. Variable annuities get even more expensive when you add in the extra fees noted above. As a result, they end up nearly two points below the performance of the average mutual fund. Two percentage points is a huge amount -- especially when it's compounded through the years. Strike three.

Three strikes -- they're out.

Comments

[Beastlike]

Is the 6.72% annual return of the variable annuity after all the fees or before?

[FMF]

I think it's after all fees.

[Norma]

If they are such a bad idea who buys them? The uninformed investor?

[Beastlike]

I hope so!

[Contango]

Variable annuities may well be an abysmal way to invest retirement funds, but this post does not convince me of that.

A 2.39% annual expense charge may be higher than would be paid by an individual investing in mutual funds, but it seems to me it compares favorably to what someone would pay a money manager to handle their funds. While an inexperienced investor might appreciate either turning their money over to a manager or buying a standard product like a variable annuity, they would likely not feel the confidence to do their own investing in mutual funds with the money they have to live on.

Also, something doesn't smell right in that comparison between the annual return for money invested in a V.A. versus the average mutual fund return. It sounds like actual account values are being used for the V.A. figure, while fund company "results" are shown for the mutual funds. It is well known that the returns investors actually get from mutual funds badly trails the funds' posted results, because of poor individual investing practices. You've got to compare apples to apples.

I could be wrong, but is there not a certain guaranteed continuing income level that a V.A. purchaser will receive regardless of how the market performs in the future? I don't think that feature is offered by money managers nor is it carved in stone for an individual doing his own investing. Why was this point not mentioned in the post?

[Maj]

The fact of the matter is that the 2.39% is exclusive of the fees of a money manager is mute considering the far majority of VAs are sold through money managers, so really the average expenses should be higher.

Also I am not sure the difference between "results" and account values you speak of. But for me there is no other way to measure returns except for the NAV returns for mutual funds, and the AUV return for VAs. Measureing the NAV returns for VAs shows nothing as it does not include all the VA fees, while all fund fees are included in the NAV. Basically there is no way to spin the fact that AUV returns will always (and by always i mean 100% of the time) be lower than the NAV returns. Also the 2% discrepancy shown does not surprise me as there are tons of fees (aside for the the fees noted in the article) that can be tacked on to a VA subaccount/policy.

There is guarenteed income with a VA, however this is looking at a long term investment in a short term scope. Over the long term if you pick decent funds (or better yet index funds) your returns will be better than the guaranteed income generated from the VA. So basically you are passing along the mutual fund returns to the insurance company and trading it in for less income. I think a much better solution is just to invest in the mutual fund, as the chance of loosing money not very high over the long term and is not worth the huge fees you are paying for the VA. Any way you cut it, VAs are a rip-off 99% of the time.

[Anon]

What has been written on this thread is correct, but misses an important exception. There is a low cost no-load variable annuity available from Vanguard. For the very few high tax bracket people who are wealthy enough to max out their employee retirement plans, max out their IRA's, buy and hold total stock market index mutual funds in their taxable account, and still have additional money to invest in bonds or REITs for use decades later in retirement (after age 59 1/2), the Vanguard Variable Annuity will save them considerable money because the tax deferral for them is worth more than the additional costs of the annuity. In some states, an annuity may also protect this retirement money from being lost if they are successfully sued in the future and get a judgment against them. Again, this makes sense only in these limited circumstances, and only if the annuity costs are very low - such as with the Vanguard Variable Annuity. (Professor William Reichenstein's book "Integrating Investments and the Tax Code" has the calculations that verify this.)

[Embarrassed to put my name]

I was talked into rolling my 401(k) from a previous job into a variable annuity within an IRA. I realize this is my own fault for not doing my research before hand, but the sales pitch was too tempting (which should have been my first clue).

Everything I read seems to say that this is the worst idea. I have two questions I'm looking for help on: (1) are there any cases where the variable annuity is a good choice, and (2) If not, is there any way to get out of a variable annuity in an IRA?

Background if this helps, I'm 33, married, with one child. I've had the annuity for about 4 years, and it has about $50k in it.

Any help wold be appreciated!!!

[Embarrassed to put my name]

that should be "any help WOULD be appreciated"

[FMF]

Embarrassed --

I'll post your question in October and let FMF readers take a shot at it.

[Money Guy]

Embarrassed --

The information you have provided here really isn't enough for me to say whether or not the VA is a good vehicle for you. I am an advisor and sell a lot of VA's, and I agree that they aren't for every client...but they are GREAT for lots of clients too!

One thing skeptics OFTEN leave out of their critisism is the VALUE the VA can provide over other investment vehicles. (Would you not agree that cost is only an issue in the absense of value?? - otherwise why would anyone buy a Mercedez for $100k when they could buy a Toyota for $13k? If all cars really provided the same value, then nobody would buy the Mercedez!!)

One MAJOR factor is tax deferral, however since your money was already in and IRA, it already qualified for tax deferral, so that wouldn't be an argument for the VA in your case. (Just wanted to make the point, because that can offset lower comparible investments bigtime.)

However there are other income and guarantee features that VA's can provide that mutual funds just can't do. Let me give you an example. I had a client, he was 56 and his wife 54 at the time I met with them. We consolidated 2 old 401k's and 1 IRA into 1 VA account, worth about 186,000 combined - we consolidated these accounts in August of 1999. My client ended up passing away unexpectedly in May 2003 at which time his account value had dropped to just over 130,000. Since the VA is an insurance contract, the VA company wrote his wife a check for 186,000 which made a MAJOR difference towards her income needs. So, for critics to make blanket statements that VA's are 'expensive' is just naive and moronic.....let me ask you Mr/Mrs Embarrassed - what would have been more 'expensive' for my clients - mutual funds or the VA??? This is just one example and just one way VA's can be better.

Another example. Let's say you get to retirement and you have $1M in a 401k and you're trying to decite between a VA and Mutual Funds. Let's also assume you need to pull $50k of income from your investment each year to pay your bills and do your retirement thing. (That is all pre-tax money, therefore all income taken is taxable 100%, regardless of what investment its in, so I won't even address the taxes.)

Now, let's say the first 2 years in retirement the S&P500 is down 12% and 10% respectively. Combine that with your 50k of withdrawals for income and your mutual funds are now worth just $707,400 and you're only 2 years into retirement!! This is a very real possibility. A $50k withdrawal in year 3 now represents about 7.1% of your total nest egg. A couple more down years in market returns and that withdrawal percentage will continue to skyrocket, drastically increasing your odds of RUNNING OUT OF MONEY IN RETIREMENT!!!

Now assume you put the $1M in a VA with a 5% income guarantee that you can't outlive (these are extremely popular today.) Your account value may also be at the $707,400 mark (maybe lower if the fees are higher right??), however you would still be able to pull $50k/year for the rest of your life, REGARDLESS of whether or not your account value ever goes back up! That is huge, mutual funds can't hold a candle to that.

Again, I realize they aren't the best fit for everyone, but you may just have a better investment vehicle than you think! You probably just don't understand it correctly.

Hope that helps.

[Anon]

Thanks, FMF, for illustrating a convincing insurance sales pitch - which shows why so many suckers make guys like you rich.

Your comments about losses in stock market investments in an annuity are a red herring, because your customers should not invest in stocks in a retirement plan or annuity. Stocks (or stock mutual funds, etf's, etc.) should be held in extremely low cost (~0.1%) tax efficient total market index funds in taxable accounts where they get preferential tax treatment, not in retirement plans or annuities where following your advice converts low taxed capital gains into high taxed ordinary income.

Also, using an expensive annuity to insure against long term stock losses is a horrendously bad bet, both because stocks historically rise over the long time period of investing that is a prerequisite for an investment with tax penalties for taking out money before age 59 1/2, and because the insurance is vastly overpriced for this purpose.

People who fall for such sales pitches clearly don't understand that if the risk free real yield of bonds (after inflation) is about 2.5% (the real bond yield available from treasury inflation protected securities), that buying an annuity to hold your bond investments that costs 2.5% in expenses means that you are handing over 100% of your lifetime investment earnings to the salesman.

Yikes!!!

High priced annuities are suitable for nobody. Selling a high priced annuity inside a tax deferred retirement account (401(k), IRA, etc.) should be a felony.

[Anon]

P.S. The talk about having lifetime income that you can never outlive is also a red herring. That is no reason to buy a tax deferred annuity while working.

A life income immediate annuity purchased at retirement, if low cost, at a sufficiently high interest rate, and from an insurance company that won't go broke during your retirement can be a great idea, if you don't care that your heirs get nothing when you die. (This allows the people who die soon to keep the people who live much longer than average from running out of money.)

But, if you want this, you should invest using low cost mutual funds, and only years later - when ready to retire - purchase the immediate annuity. Why prematurely pay annuity fees to an insurance company during your whole working life for no reason?

[Tom]

Thanks Money Guy, I liked your reasoning on why VAs are bad investments. But I am confused about your comment that stocks (mutual funds, ETFs etc) should not be held in retirement plans. For the majority of us who have and are still contributing to retirement plans (e.g. 401Ks, 403Bs) what asset class do you recommend we hold if not stocks?

[Money Guy]

Anon: I'm not referring to an immediate annuity which required annuitization in exchange for a lifetime income stream. I'm talking about a variable annuity with an income rider benefit that provides the income guarantee without having to annuitize the contract and lose control of your nest egg to the insurance company. So yes, your family does still receive a lump sum when the owner dies, in fact in many cases the surviving spouse can continue the lifetime income payments even for the rest of THEIR life too even if withdrawal amounts exceed the original investment amount. Tell me what mutual fund can do that???

Also, in one specific annuity I sell clients are guaranteed to double their money in 10 years, worst case scenario. So if their super duper low cost mutual funds or etf's don't happen to average 7.2% return over a 10 year period, (which a lot do, depending on which 10 year period you look at) then the client has a safety net to rely on. However if your fancy mutual funds/etf's average 7.2% or greater, then I'm confident that the VA subaccounts will do the same, even net of fees.

Lastly, I've already admitted the fact that VA's aren't suitable for every client out there, I recognize that and don't recommend them for all clients, but neither are mutual funds or etf's suitable for clients that are so scared of the market that they keep their retirement money in a damn cd or money market account that barely keeps up with inflation.

[Jake]

"... I'm talking about a variable annuity with an income rider benefit that provides the income guarantee without having to annuitize the contract and..."

It must be much easier to pull the wool over people's eyes when you dramatically increase the complexity of the thing you're talking about.

What kind of commission do you make when you sell a VA? What kind of commission do you make when you sell an ETF? If client A invested $1,000,000 in a VA and client B invested $1,000,000 in a vanguard ETF with 0.10% expense ratio, which client is doing more to pad your pockets? Would you rather have a client for whom a VA is appropriate or a client for whom an ETF was appropriate?

I've never met a fee-only (zero commission) advisor who put anyone in an annuity with 2%+ expenses.

[Money Guy]

"....Would you rather have a client for whom a VA is appropriate or a client for whom an ETF was appropriate?..." - I'll take many of each type.

Does this specific client want a guaranteed income stream that they can't outlive?

[Fee based Advisor]

I'm with Money Guy on this one. I'm a fee-based advisor as well as a Principle at our firm who reviews all of the trades at our firm for suitability. I see and have many clients for whom the VA with an living benefit rider is perfectly appropriate and in fact beneficial over mutual funds or ETFs. Admittedly these are complicated vehicles which require a lot of time and explanation to clients. In cases where it makes sense (clients and I decide together what is fair compensation for my work) I may waive portions of their annual fees if a VA sale produces a large commission outside of the fee we've agreed upon.

Those who have made comments about "pulling wool over eyes..." etc. I want to know if you feel like your attorney, dentist, or accountant is "pulling wool over your eyes" when they recommend a procedure or treatment that is expensive? People hire advisors (of all kinds) to help them - there are better advisors than others, true. And like all professions there are people who will take advantage of others unfortunately. However, for an advisor who spends the time to really get to know a client and find the right products for their needs, doesn't it make sense to compensate them? I get the feeling some people believe we should dole out good advice for free. Why is that fair? There would be no good advice available if we didn't pay for good advisors.

Anyhow, Money Guy. We can't save the world in one fell swoop, but I'm with you on this one.