The One Article You Need to Read Before You Buy a Variable Annuity

There has already been a lot written about variable annuities and for good reason. It is hard to walk into a bank without hearing the argument that you are leaving money on the table given the low interest rate offered in savings accounts. This is a perfect segway to pitch a variable annuity. In my experience working with clients, these products are oversold to people that don’t fully understand them and ultimately don’t really need the features that they offer. So, let’s talk about what a variable annuity is, what some of the common benefits are, and most importantly some of the misconceptions and drawbacks of these products. Hopefully this will help you make an informed decision on whether a variable annuity is right for you.

In its most basic form an annuity is a contract between you and an insurance company where you give the insurance company money in a lump sum or over a specified period, and in return they agree to pay you an income stream (usually for life) once you decide to annuitize the contract. The main purpose of this product is longevity insurance. There are few guaranteed sources of income in retirement outside of Social Security or a pension plan. We are living longer lives and many retirees face the risk of outliving their retirement savings, so trading some of your savings now for a guaranteed income stream in retirement may not be a bad thing.

A variable annuity is a type of annuity contract that allows you to accumulate money in a subaccount where it is invested and grows on a tax-deferred basis. When you retire, the issuer will pay you a certain level of income based off the performance of the investments chosen. Essentially, you combined an investment product that grows tax-deferred until retirement with longevity insurance to mitigate the risk of outliving your money. Here are some other common features of a variable annuity.

Death Benefit- Most variable annuity contracts offer a death benefit to the beneficiary of the policy if the policyholder or annuitant were to die. The benefit is usually the amount paid into the annuity minus any withdrawals or the current contract value, whichever is higher. For an additional fee, some contracts offer an enhanced benefit that guarantees the death benefit will increase on the policy even if the market value does not.

Living Benefit- Contracts can offer benefits that the policyholder or annuitant can take advantage of while they are still living. For an additional fee, features can be added that guarantee a minimum level of income when you retire (Guaranteed Minimum Income Benefit), guarantee that you will at least get back the principal that you put in when you annuitize (Guaranteed Minimum Withdrawal Benefit), or guarantee that you will receive all your principal back after a certain holding period (usually 5 to 10 years) regardless if you annuitize the contract or not (Guaranteed Minimum Accumulation Benefit). Some of the newer products offer a benefit that allows you to take out money tax-free to pay long-term care costs.

So far so good, right? You get to participate in the performance of the stock market, have an income stream in retirement all while having the ability to leave a benefit to your beneficiaries and put in safeguards in the form of guaranteed riders to ensure a certain level of income and/or principal protection. Now let’s talk about some of the drawbacks or misconceptions of these products.

Everything comes at a cost…First, there is the basic insurance cost of an annuity which is paid through the Mortality and Expense Risk (M&E) Charge. There is also an administrative cost to service the policy, and potentially a surrender charge if you were to withdraw money from the contract before a stated surrender period which could be as long as 10 years. The subaccounts that are invested in also have their own underlying fees. As stated earlier, the enhanced death benefit or other living benefits are added to a policy for an additional fee. All in, just the M&E, administrative, and investment fees can easily pass 2% annually, and if optional benefits are added, the fee can be much higher.

Clearing up the tax benefits… Since you already receive tax-deferred treatment on contributions to a qualified (retirement) account, you only see an added tax benefit in a non-qualified (non-retirement) account. It’s also important to understand that the contribution is not made with pre-tax dollars. Therefore, there is no immediate tax benefit on the contribution. The only tax deferral benefits you are gaining is on the potential investment gains. But remember, in a variable annuity these gains will be taxed at the ordinary income rate when you withdraw or annuitize the money, not the long-term capital gain rate which is usually more favorable. Withdrawals prior to age 59 1/2 may be subject to a 10% IRS penalty, also. Another difference to a traditional investment is that if you leave an investment with a capital gain to your children, the IRS allows these beneficiaries a step-up in basis where they will receive the assets at the fair market value tax-free. Without additional estate planning, that is not the case with variable annuities. Non-spousal beneficiaries will be responsible to pay the tax on the gains from your original investment.

The word “Guarantee” is thrown around a lot but…Do these contracts really protect my money from a market downtown? Yes and no. These contracts usually guarantee a certain level of death benefit or income stream if you were to annuitize the contract in retirement. In most cases, they are not guaranteeing a certain market value in the account if you were to surrender the contract or needed to make a withdrawal. In this case, you will receive the market value at the time, minus potential tax penalties and any surrender fees if it is still in a surrender period. If the market is lower than where you invested the money, you will be subject to investment losses. As with all insurance products, all guarantees are based on the claims-paying ability of the issuing insurance company.

Other things to consider…The surrender period itself is a reason that a variable annuity might not be a good investment choice. During the surrender period, you could be penalized for withdrawals, so a variable annuity is not considered a liquid asset. Another drawback is that you are limited to the investment choices offered within the annuity. An investment account could offer you many more choices of mutual funds and ETFs, potentially at a lower investment cost.

I should also mention…It may seem that I am pretty hard on variable annuities in this article, but I should mention a couple of other benefits. Depending on your state, the value in these contracts may be protected from creditors. Also, the proceeds of a variable annuity avoid probate when they are paid to your beneficiary.

I hope this article clears up some of the misconceptions of this popular financial product. If you are unsure about the risks and costs associated with a specific variable annuity contract or if it is the right product given what you are looking to achieve, please reach out and I’d be happy to help.

Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Guarantees are based on the claims-paying ability of the issuer. Withdrawals made prior to age 59½ are subject to a 10-percent IRS penalty tax, and surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. The investment returns and principal value of the available subaccount portfolios will fluctuate, so the value of an investor’s unit, when redeemed, may be worth more or less than the original value. Optional features available may involve additional fees. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Securities offered through LPL Financial, Member of FINRA/SIPC and investment advice offered through Stratos Wealth Partners Ltd., a Registered Investment Advisor. Stratos Wealth Partners, Ltd. and Lob Planning Group are separate entities from LPL Financial.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.