Live business advisors standing by Toll Free

888-893-2990 (M-F, 7AM - 4PM PST)

Only Narrow Minded People Debate the Pros and Cons of Variable Annuities

Published on September 16, 2008 in variable annuities by Bob Richards

Some conversations in our industry 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 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.  We actually talk to and care for the people we 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.  And then 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.  In other words, as advisors, our job 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 if 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).  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.

This post provided by Javelin Marketing

Click to meet annuity buyers in your area.

13 thoughts on “Only Narrow Minded People Debate the Pros and Cons of Variable Annuities

  1. Moving Pods Prices says:

    I agree that variable annuities are largely crap.

  2. peoplex-ray.com says:

    The proponent that are arguing may be doing so out of greed or else why the defense for offering their client less than the best option. Tax deferrement as a way of saving for future retirement will benefit younger investors more than older investor- the economic outcome proof this. So why the arguement?

    peoplex-ray.coms last blog post..Online Background Checks Buyers’ Review Guide

  3. You didn't mention the fees of the VA as a downside, or the fact that there are limited investment choices.

    Bryan Andersons last blog post..Equannuity

  4. Very provocative post. Yes it is interesting to see that most mainstream media are against annuities. For some people, they are the right financial product to buy.

    I do think though that there needs to be some more regulation on how these products are sold. It is not uncommon for some unscrupulous individuals to prey on the elderly.

  5. chat sitesi says:

    The proponent that are arguing may be doing so out of greed or else why the defense for offering their client less than the best option. Tax deferrement as a way of saving for future retirement will benefit younger investors more than older investor- the economic outcome proof this. So why the arguement?

  6. chat odası says:

    Thanks admins nice post love you
    I agree that variable annuities are largely crap.

  7. Netbooks says:

    WITH THE WAY THE CRUNCH IS AFFECTING PEOPLE, WILL THIS ALSO HAVE AFFECT MY ANNUITY?

  8. Dave says:

    I totally agree that that variable annuities are largely crap.

  9. eyelashGirl says:

    Variable annuities are not the way to go. And many companies out there are just looking to take advantage of the seniors.

  10. brittany says:

    Asset allocation options are limited within an annuity. Some contracts have predetermined portfolio balances and others will list a limited number of available mutual funds. The combination of investment limitations and surrender charges means that your money is much less mobile than it would be in an equivalent securities account.

  11. Sandra says:

    I agree that variable annuities are largely crap. Tax different as a way of saving for future retirement will benefit younger investors more than older investor- the economic outcome proof this.

  12. zoe says:

    In general however, VAs are more suitable for younger, not older investors, as younger investors get more benefit from longer deferral.Some argues that the tax benefits of VAs are poor and the advisors.However,in general, VAs will be most suitable for growth oriented younger investors.

  13. Variable annuities allow you to pursue portfolio gains through a variety of sub accounts, which can be invested in securities such as stocks and bonds. However, with this added growth potential comes additional risk. During periods of market volatility, your principal and monthly payments may fluctuate or fall below their initial value. Planning for a lengthy retirement is no easy task — especially in light of the recent bear market. Variable annuities may help add growth potential to your portfolio.

Leave a Reply

Your email address will not be published. Required fields are marked *

Coupons