While driving home recently I was disconcerted by another commercial spouting false information and preying on investor fear. This commercial was exaggerating the danger and volatility of the stock market by implying most investors lost millions in the 2008 and 2009 market crash. In reality if you were invested in the stock market from 2006 to 2016 you would have seen a 65% increase in your stock portfolio. If you didn’t sell when the market dropped, you would have experienced a reasonable return rather than a loss on your investment. Commercials like this stir up fear and anxiety then promise the perfect solution to market volatility – the magic to provide great returns without taking risk.
There is no miracle product that is going to provide you with high returns without risk. If it sounds too good to be true, it is! A basic concept of investing is the trade-off between risk and return. If you want more return you will have to absorb greater risk. If you want a risk free investment you will be limited to CD’s and US government bonds that pay very low interest rates. If you want to earn higher returns you will need to take on some risk and invest part of your portfolio in the stock market.
The mystery product in commercials and ads that promise high returns with no risk is often a variable annuity. While on occasion the use of an annuity may be appropriate for a portion of your portfolio, most variable annuities come with significant disadvantages. A variable annuity is an insurance vehicle that invests your money into separate accounts similar to mutual funds. Annuities are complex insurance contracts that are commonly sold on commission, with built-in fees and significant restrictions on when and how you can withdraw your money. Earnings on money invested in a variable annuity grow tax deferred but are taxed at regular income tax rates when withdrawn.
Insurance salespeople influence you to buy annuities by promising protection from market volatility. Basically, in addition to paying the typical fees and commissions, you can purchase an insurance rider to guard against a drop in the market. However, this insurance usually only applies to a death benefit or the base amount used to calculate an annual income stream. If you think a variable annuity is appropriate for your situation make sure you fully understand the product’s benefits and restrictions before investing. Also consider an annuity with no or a low commission and without restrictions on when and how you can access your money.
A better option for managing market volatility may be to invest in a diversified portfolio that supports your time horizon. Avoid the need or temptation to withdraw money from the stock market when it’s down. Invest money needed in the short term in safe investments and limit your stock market investments to long term money.
Jane Young, CFP, EA
A variable annuity is an investment contract with an insurance company where you invest money into your choice of a variety of sub-accounts. Sub-accounts are similar to mutual funds, where money from a large number of investors is pooled and invested in accordance with specific investment objectives. Like mutual funds, sub-accounts may invest in different categories of stock or interest earning investments.
One characteristic of a variable annuity is the tax deferral of gains until the funds are withdrawn. However, upon distribution the gains are taxable at regular income tax rates, as opposed to capital gains rates that may be available for mutual funds. Additionally, there is no step-up in basis upon death for assets held in variable annuities.
Variable annuities are generally more appropriate for non-retirement accounts because gains within a retirement account are already tax deferred. Traditional retirement accounts and Roth IRAs meet the tax deferral needs for most investors. However, in some cases a variable annuity may be attractive to a high income investor who has maximized his traditional retirement options and needs additional opportunities for tax deferral. This is especially true for an investor who is currently in a high tax bracket and expects to be in a lower tax bracket in retirement.
When investing in variable annuities, with non-retirement money, there is no requirement to take a Required Minimum Distribution at 70 ½. However, there is generally a 10% penalty on withdrawals made before 59 1/2. Trades can be made within a variable annuity account without immediate tax consequences. The entire gain will be taxable upon withdrawal. There is no annual contribution limit for variable annuities, and you can make non-taxable transfers between annuity companies using a 1035 exchange. However, you may have to pay a surrender charge if you have held the annuity for less than seven to ten years, and you purchased it from a commissioned adviser. Before buying an annuity, read the fine print to fully understand all of the fees and penalties associated with the product. Most variable annuities have early withdrawal penalties and a higher expense structure than mutual funds.
A variable annuity may be an option for someone who wants to purchase an insurance policy to buffer the risk of losing money in the market. For many investors, due to the long term growth in the stock market, this guarantee may be come at too high a price. Some investors are willing to pay additional fees in exchange for the peace of mind that a guaranteed withdrawal benefit can provide. Guaranteed minimum withdrawal benefits (GMWB) can be very complex and have some significant restrictions. Additionally, some products offer a guaranteed death benefit for an extra fee. Read the contract carefully and make sure you understand the product before you buy.
Due to the high costs, lack of flexibility, complexity and unfavorable tax treatment variable annuities are not beneficial for many investors.
Jane M. Young CFP, EA
Due to the high costs, lack of flexibility, complexity and unfavorable tax treatment variable annuities are not beneficial for most investors. Traditional retirement accounts and Roth IRAs meet the tax deferral needs for most investors. In some instances a variable annuity may be attractive to a high income investor who has maximized all of his traditional retirement options and needs additional opportunities for tax deferral of investment gains. This is especially true for an investor who is currently in a very high tax bracket and expects to be in a lower tax bracket in retirement.
Generally, money in retirement accounts should not be invested in variable annuities. The investor is already receiving the benefits of tax deferral.
A variable annuity may also be an option for someone who is willing to buy an insurance policy to buffer the risk of losing money in the stock market. For most investors, due to the long term growth in the stock market, this guarantee comes at too high a price. However, some investors are willing to pay additional fees in exchange for the peace of mind that a guaranteed withdrawal benefit can provide. A word of warning, guaranteed minimum withdrawal benefits (GMWB) can be very complex and have some significant restrictions. Do your homework, make sure you understand the product you are buying and read the contract carefully.
According to a study conducted by David M. Blanchett – the probability of a retiree actually needing income from a GMWB annuity vs. the income that could be generated from a taxable portfolio with the same value is about 3.4% for males, 5.4% for females and 7.1% for couples. The net cost is about 6.5% for males, 6.1% for females and 7.4% for couples.
Jane M. Young, CFP, EA
What is a Variable Annuity?
A variable annuity is a contract with an insurance company where you invest money into your choice of a variety of sub-accounts, similar to mutual funds. Non-qualified, variable annuities provide tax deferral on gains until the funds are withdrawn. Upon distribution your gains are taxed at regular income tax rates as opposed to capital gains rates. Variable annuities generally charge fees twice those charged by mutual funds. Additionally, you will be to subject to substantial early withdrawal charges if you purchase an annuity from an advisor who is compensated through commissions. Most variable annuities provide the option to buy a guaranteed death benefit option and/or a Guaranteed Minimum Withdrawal Benefit. These do not come without a cost and can be very complex. Below are some advantages and disadvantages of Variable Annuities.
Advantages and Disadvantages of Variable Annuities:
- Tax Deferral of gains, beneficial if you have maximized limits on other retirement vehicles such as 401ks and IRAs.
- No Required Minimum Distribution at 70 and ½ as with traditional retirement accounts. There is no Required Minimum Distribution on Roth IRAs.
- Death benefit and Guaranteed Lifetime Withdrawal Benefits (GLWB) riders can be purchased for additional fees. However, the death benefit is rarely instituted due to long term growth in the stock market. GLWBs can be very complex and not without risk.
- Trades can be made within annuity without tax consequences – this is also true within all retirement accounts.
- Non-taxable transfers can be made between companies using a 1035 exchange.
- No annual contribution limit. Traditional retirement plans have annual contribution limits.
- Gains taxed at regular income tax rates as opposed to capital gains rates on taxable mutual funds.
- Higher expense structure –Mortality and Expense fees substantially higher than mutual funds.
- Substantial surrender charges for up to 10 years on commission products
- 10% penalty on withdrawals prior to 59 ½, this is also true with most traditional retirement accounts.
- Complex insurance product
- Lack of liquidity due to surrender charges and tax on gains
- No step-up in basis, taxable mutual funds and stocks have a step-up in basis upon death
- Loss of tax harvesting opportunities