Learn How Variable Annuities Work. Be armed with knowing the benefits and the pitfalls of this product before deciding if this is something you should invest in.
Variable Annuities The Good The Bad and The Ugly
Back in August we did a series on variable annuities. These complex investment vehicles can be confusing and dangerous to your portfolio if you are not educated on the specifics. My goal is to arm you with education to make sure when you are sitting with a financial professional that you are able to cut through the confusion and be able to make smart sound investment decisions.
How a Variable Annuity Works
In the variable annuity video on this page I simplify some of the complexities that come along with this product. This will give you a great visual of what is happening to your money when it is invested in this type of annuity.
Knowing your options is key to making a wise decision. Don’t ever let someone tell you, you only have one option. There are many options and they all need to be put to the test based off of your end goal.
Variable Annuities Transcription
Good morning Vero Beach. Welcome to the Financial Pulse radio show. I’m your host Danny Howes, CEO of East Coast Tax and Financial Planning firm right here in the island. Welcome, welcome. I hope everybody has had a great week. We are in the thick of tax season. Of course at East Coast Tax and Financial Planning we do taxes for small and medium sized businesses. We actually do full service accounting and bookkeeping and that kind of thing. And of course we handle tax returns and we also do that for individuals and families as well. So if you need that, go to our website.
This is variable annuity week. We’re going to talk about variable annuities. They’re a hot topic. Lots of people listening may have one or have thought about buying one, or has had somebody pitch in that might be a good fit for them. They’re very complex instruments and so I really wanted to devote the next couple shows in the next couple weeks to annuities in general. We have fixed index annuities, fixed annuities, single premium annuities, immediate income annuities, and of course we have the variable annuities that we are talking about today.
The basic of an annuity is that it’s an insurance contract first. First and foremost it’s an insurance contract. It’s not like you’re buying a stock or bond or something like that. It’s investing in an insurance contract. With a variable annuity, it is a group mutual funds with an insurance contract wrapped around it. That insurance contract can have all types of nuances and bells and whistles as far as what kinds of benefits you can receive, and what kind of guarantees, and what some of the pitfalls and the rules to the annuities are. Rules are really important to think about and consider when it comes to variable annuities because you have to remember that insurance companies are not stupid. They’re the ones that actually invented these things. So, if the insurance company is putting out a contract for you to potentially invest in and make money, they’ve got their interest in mind, too. They want to make money as well. So the more complicated they can make in investment, the easier for them to make money because the easier it is for people to miss something or misunderstand something, and not fully grasp exactly what they’re buying or investing in, and really only paying attention to the shiny bullet points that are out there as far as the benefits of that annuity but not necessarily the meat and potatoes.
So, the mutual funds are wrapped around by an insurance contract. That is the annuity. The owner of the annuity is usually the same as the annuitant. The annuitant is basically the person that’s going to benefit from the annuity. They’re the ones that’s if it’s there’s going to be income from it, they will be taking the income. There are some cases where somebody else might be the owner, or they have joint ownership. But that’s basically the way that it’s structured. Now the mutual fund inside of that annuity, that’s what they are: mutual funds, they’re invested in the market and there’s a whole plethora of mutual funds to choose from according to your investment objectives and your risk tolerance. But there are a few things to keep in mind. One of the big things that give annuities or variable annuities, in particular, is the fees. What’s difficult about that is many times half the fees aren’t even on the monthly or quarterly statements that you receive. You don’t even know or see those fees going out. Now they’re buried in the prospectus that you got when you initially took that annuity out and they’re buried in the policy so you can find these fees in the policy but it’s not one of those things where it’s really easy and identifiable. So it’s not uncommon for us to run into what they call mortality and expense charge on all of variable annuities. And that mortality and expense charge is charged by the insurance company, and that can be anywhere from half a percent to one and a half percent even two percent. That’s an annual charge.
You also have what they call rider fees. We’re going to get into riders in the second segment because it’s just a pretty heavy subject because there are so many different ways they can work and the pitfalls and opportunities that are with those riders. Many times people buy an annuity just because of the rider benefits. We’ll talk about that in the second segment. Those rider fees can add up to anywhere to one to two percent as well. So if you look at it, let’s say we’re paying one and a half percent in the mortality and expense charge, and let’s say we’re paying one and a half percent in rider fees. That’s three percent. But let’s say, maybe we have two riders: a death benefit rider and income rider. There’s another one and a half percent potentially. You can easily see you can rack up to 4 to 5% in fees on variable annuities.
Now let me ask you this question. If you want to make 5%, what do you have to earn in order to make 5% if you’re paying 4% in fees? It doesn’t take a math scientist, right? It’s 9%. If I don’t want to lose money, if I just want a flat year – I don’t make any money, I don’t lose any money – what do I have to earn? I have to earn 4% because they’re going to charge that account 4% regardless of whether the market is up or down. It’s like gasoline on a fire if the market’s going down, right? Because if the market or your investment, those mutual funds, are down by 5% but we have 5% of fees on top of that; now we just lost 9%. And let’s say you are starting to take income or the required minimum distributions out of the account. So now we’re taking out about maybe another 3, 4 or 5% so it wouldn’t be uncommon in a market where investments are down only 5% but because you are taking money out on maybe 3, 4, or 5% and because they’re charging 4% in fees, you could see a 12 to 15% decrease just because of a 5% drop due to additional fees.
Of course when you take money out of the account of your money but you’re paying taxes on those cases, and so on and so forth. But that’s not all variable annuities. I want to make that very clear. They have a bad rep because of the fees, and because of the complexities, and because of how confusing they can be, but not all variable annuities are created equal just like anything else. There are annuities out there that are actually very fee-friendly where you may only see one or two percent. I’ve seen them with a half of a percent in fees. They are different share classes within variable annuities. The share classes are much like mutual funds. The share classes really determine many times who can invest in them so you’ll have institutional class mutual funds where they want certain large dollars in that particular fund so they may have a million dollar investment minimum. Then you have like Vanguard has admiral shares from other mutual funds where if you have at least a hundred thousand dollars to deposit into the fund, you actually get a break on their fees.
But then you have share classes that have to do with how the broker is compensated for selling you the annuity. So the broker actually has some control over how much the fees are going to be. Because if they have the control over what share class they’re going to give to you, that directly impacts their commission. That’s where the fee can actually be adjusted or different. You can have two annuities that have the same benefits and the same riders and the same underlying investments, but they can have completely different fee structures because of how the commission is paid out to the broker. Something very important to keep in mind is to ask your broker. If you’re looking at a variable annuity, there are other share classes that we can entertain and look at.
Surrender charges are a big thing, too because most variable annuities have a surrender period. Of course the shorter the term, the better off it is for you because if you ever want a change at an investment, you can do so.
We’re going to wrap up this segment. Next segment we’re going to talk more about those share classes and how those fees and commissions work. We’re also going to dive deep into the riders which are the bells and whistles that people choose to purchase annuities base on.
Go to www.eastcoasttaxandfinancial.com. I’ve done a video there about variable annuities and how they work. If you want more information we also have a blog there where you could read some of the information that I’ve shared with you today. We go in depth a little bit more but just go ahead and go to our website www.eastcoasttaxandfinancial.com. You can watch the video, listen to past shows. We did this back in August. There are a lot of great materials that we put there back in August. You can do some research. It’s all about empowering you with knowledge in just a bit.
Welcome back to the Financial Pulse radio show Vero Beach. My name is Danny Howes. I am your humble host and CEO of East Coast Tax and Financial Planning. A local firm right here in Vero Beach. We dedicated this week to variable annuities. I hope you’ve learned a lot from the last segment. I tried to pack in a lot of stuff as fast as I can but we only have so much time on the radio. So you can go to www.eastcoasttaxandfinancial.com and you can actually watch more videos, listen to past radio shows on this topic. I have a variable annuity video there that goes more in depth and explains how it works. So you can make yourself more informed. There are blogs on there so what we are trying to do as much as we can to help you be educated and to watch out for it.
Variable annuities. We talked about the fact that the money that gets deposited into annuity is mutual funds. So they are invested in mutual funds. The annuity is an insurance contract wrapped around a bunch of mutual funds. Your money can go up and it can go down in value based off whatever the underlying performances of those funds are. Last segment we talked about the dangers so many times a lot of these annuities can be really fee-laden; heavy on fees. 4 or 5 percent in fees sometimes, so it makes it very difficult to make money.
This segment I want to talk about the bells and whistles that most people purchase variable annuities based on, and that is riders. The most common one are income riders. Remember the three-legged stool we talked about last week? You know the three-legged stool of retirement income is social security is one leg, pension is another, and then the third leg is income from investments. So what’s happened though is pensions have gone the way of the dinosaurs. Nobody gets those anymore unless you work for the government or health care, or something like that. With 10,000 baby boomers a day are retiring, we have all these people who need retirement income. When you look at the income from investments in an interest rate environment that the government has basically engineered to zero interest rates; how is somebody supposed to invest money to save CD’s or bonds, and just live off the interest and preserve the principal? It’s very difficult, right?
That’s where annuities come in play many times because you can get guaranteed income and guaranteed security from them if you choose the right one. It can help put another third leg on that stool and replace the pension. Well, with the income riders think about this. Just imagine drawing a line down on a piece of paper and you could do this if you are at home. Just on one side of the line just write cash value and on the other side of the line, we’re going to write income value. Income account value is basically a calculation. It’s not a cash value. It’s not real money. It’s just a calculation of formula the insurance company is going to use so that if you’ve ever decided you want to take lifetime income from that annuity, they’ll base it off of that guarantee. What they do many times is called a roll up.
So on that side of that ledger the way to calculate your future income they’ll say “What we’re going to do is we’re going to grow this side by 6, 7, 8 – I’d even say 10% per year on the income account value growth.” Again, it’s not real money. That is just the way they are going to calculate your guaranteed income if you’ll ever so choose to take it. On the left hand side is your cash value and that’s growing and hopefully not losing according to whatever the underlying mutual fund investments are performing. So it’s very difficult for that cash value to ever really keep up with that income account value because the income account value has a guaranteed growth. So what can end up happening is what I call golden handcuffs where you wake up one day and you say, “No I really don’t like this investment anymore. I don’t think I’m going take the income. However, my cash value is like 20, 30 percent less than what my income account value is.”
So then you have this golden handcuffs type of scenario where “Gee that’s an awful lot to give up, maybe I should just go ahead and take the income whether I want it or not”. So that can really make it so that you don’t have so many choices or options. And so, the income account value grows just like that. But one thing you have to be careful with on income account values the little rules and tricks of insurance companies. They are not stupid, remember? They want to make money. There are little rules and tricks that they put in there that can actually blow up that income rider. Meaning they’re making it null and void or not as attractive as what you thought originally. Sometimes that could be a withdrawal because they have withdrawal rules so maybe you’ll take a withdrawal out of your account and you didn’t realize it; that could actually cancel your account value. You could have maybe you’re taking lifetime income and you need more money for whatever reason. There might be a provision in the contract that says, “Well if you do that then you stop getting your income, the lifetime guarantee is gone.” It’s something you have to be very careful about and read through.
And there’s benefit riders. Benefit riders work the same way. Let’s have the same line drawn down the piece of paper. On the left side, we’re going to have cash value just like what we had before. But on the right side we’re just going to have death benefit value. And that death benefit value works very similarly to the income account value; where though you may have a guaranteed roll up that upon your death, it triggers and that value is what they sue to pay out to your beneficiary or spouse, or whoever you’re living your money to. It can be an actual, almost death insurance or life insurance alternative for people that are maybe uninsured or an insurable and want to leave more money behind. You try to leverage your money. Or you could use that death benefit feature as an enhancement to your estate and your legacy.
You’ve got to remember in my opinion a variable annuity with a death benefit – if you could qualify for a life insurance – is almost the worst tax planning for estate planning that you could possibly do. Because annuities are taxed LIFO, last in first out, and so upon the payout of that annuity all that interest and that growth or that death benefit enhancement that has grown, is taxable to your heirs; whereas life insurance is non-taxable. But again there are certain scenarios and situations where people might want to do it. One is maybe because they are not insurable or they can’t get preferred rates. Another would be the fact that maybe you want an income rider and a death benefit rider. I would kind of just go out on a limb and say you’re probably either going to live or you’re going to die. You’re probably not going to use both of those riders, right?
So very many times I see people come in with two or three riders, maybe a guaranteed principal rider. A guaranteed income rider and a guaranteed death benefit rider. And all of a sudden “Geeez you’re paying 5 and a half percent.” You might just as well bought insurance, right? So fee efficiency is a very huge thing because if you think about it, if they’re charging you 4% and you’re withdrawing 5% and the market goes down by 5%, you’re almost like at 15% drop in asset value of your annuity. So those are the things that you have to be careful of.
We talked about share classes. Share classes are basically the way that the broker gets paid. So let’s take an A-share for example. A-shares are typically front loaded, sales charges where the broker gets one big paycheck upfront. Sometimes it can be as much as 6 or 7 percent. B-, C-, and L-shares: these are different share classes on our blog. If you want to go to www.eastcoasttaxandfinancial.com, we’ll go deeper into share classes. But other share classes will pay the broker differently. And a lot of times that can mean less cost and fees to you because many times the sales charges are bundled into why they charge so much in the first place. You really have to understand the share class so you can ask your broker, is there another share class option that I might be able to entertain that might have less cost to them to make your annuity actually more efficient.
Remember, fees make everything inefficient. It’s like blood pressure. They’re silent killers that eat away your wealth and you don’t even know it. So asking about share classes is a big, big thing in really understanding what you’re buying the annuity for without being tantalized by the income riders and the bells and whistles and percentages they’re throwing out of guarantees and so forth because you really have to redefine and print what those guarantees mean and how they work in what some of the caveats and pitfalls are.
We’re running out of time. We always do this but go to www.eastcoasttaxandfinancial.com. Click on the Financial Pulse and that will take you right in there to our blog area. You can watch some things that I’ve done on my whiteboard, some presentations. We have some blogs out there explaining about the different share classes and so forth. And I’ve got a little guide there, just something to keep at the back of your mind if you’re thinking about purchasing a variable annuity; what to do. And we also have some information if you already own one and you’re scratching your head “Geez I own this but I don’t even know if I want it.” Then give us a call because we can help you evaluate and help you manage that so that you can determine whether it’s still the best thing for you, and just really know what you have, how it works, and how it affects you, so you can make the choices.
Every single Thursday, 10:30 AM right here on WAXE Radio. Make sure you protect that money folks but most importantly, make sure you know what and who you’re protecting it from. I’ll talk to you next week; fixed index annuities.