Variable Annuity Not Magic Solution

office pictures may 2012 002While 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    Earnings on money invested in a variable annuity grow tax deferred but are taxed at regular income tax rates when withdrawn.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.

Advantages and Disadvantages of Variable Annuities

 

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:

Advantages:

  • 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.

Disadvantages:

  • 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

Join us for a Fireside Chat on Annuities vs. Mutual Funds on May 16th

Please join us for lunch and an interactive discussion on annuities vs. mutual funds at Pinnacle Financial Concepts, Inc. on May 16th. Our Fireside Chat will run from 11:30 to 1:00. Please call 260-9800 to RSVP. There is no charge and our Fireside chats are always purely educational!!!