Summary/TLDR
Variable annuities are marketed to retirees like there’s no tomorrow. Unfortunately, this is often done under the pretense of misleading promises and “guarantees” that are simply too good to be true. When it comes to analyzing the true value of the “guarantees” offered by these contracts, it’s best to start with the “internal rate of return”, which is often exceptionally poor in the case of annuities that I have looked at for clients. Beyond this, annuities often charge their contract holders grotesquely high fees (which are rarely disclosed), pay their agents very handsome commissions (introducing a conflict of interest), and can rarely (if ever) adjust their “guaranteed” income for inflation. Taken together, this makes variable annuities one of the worst tools one could equip themselves with for the purposes of retirement planning.
Introduction
Of the myriad of “investment products” available on the market, perhaps none are marketed as aggressively to retirees as variable annuities. Unfortunately, they also happen to be some of the most complex and non-transparent products on the market. Consequently, they get sold under false pretenses to unsuspecting consumers who expect them to produce “guaranteed income” and protection from the “risky” stock market. In today’s post, I’ll try and tackle some of the biggest myths surrounding these products and why I generally recommend that people avoid them.
Variable Annuity Mechanics
Variable annuities are often advertised along these lines: “Your money is invested in the market and, if the market goes up, so does your investment. Furthermore, there is a guarantee built into this annuity that says you can’t earn less than 6%. So, if the market goes down, you’ll still earn money! The most you can earn is what the market earns, and the least you can earn is 6%! Finally, when you retire, this annuity will guarantee you an income for the rest of your life, even if you outlive your money!”
Does that all sound too good to be true? Then I’m sure you won’t be surprised to learn that the full story is not nearly as rosy. When you invest money into a variable annuity, the insurance company keeps track of two “buckets” based on your investment. The first is your actual investment, which is invested into the market and from which fees are deducted. The second is an imaginary investment known as the “benefit base”. The benefit base is entirely hypothetical – it is not real money! But every “guarantee” offered by this annuity is only granted to the benefit base. This means that the 6% “guaranteed return” in our example above is not given to your actual investment. Your actual investment will still go down when the investments go down. The benefit base is only used to determine the “lifetime income” you will get from your contract. If all of this is difficult for you to follow, don’t feel bad – variable annuities are complex products.
Analyzing Variable Annuity “Guarantees”
When it comes to analyzing the value of a variable annuity, I prefer to start with what is called the “internal rate of return”. The internal rate of return of an investment is essentially the rate of return that an alternative investment would need to beat to be considered a “better deal”. By knowing an investment’s internal rate of return, financial planners/analysts can compare different types of investments to each other to determine which will yield the better results. For example, if a variable annuity had an internal rate of return of 4% but the investor found an alternative investment, say an investment property, that could reasonably provide them with an internal rate of return of 8%, then the investor would be far better off by investing in the property.
In my experience, somewhere between 90-95% of the variable annuities that I have looked at for clients have been terrible. I have found that an annuity offering an internal rate of return of 4% is well above average with most of the ones I’ve seen between 1-2%, and many even having a negative internal rate of return. Many owners of variable annuities, believing that their money is safe and sound, are essentially donating their hard-earned money to an insurance company, likely leaving little-to-nothing to their heirs.
Miscellaneous Issues
Extremely high and non-transparent costs
Variable annuities are notoriously complex products. There are four different fees charged by insurance companies on their annuity products, and not all of them are sufficiently disclosed to clients, nor are all of them viewable by clients in a statement. Rider Fees – typically 1.00-1.50% annually.
Mortality and Expense (M&E) Fees – fluctuates over the life of the contract and is usually between 0.75-1.50% annually.
Subaccount fees – usually 1.00% annually.
Administrative fees – minimal, totaling anywhere from a flat dollar amount (such as $25 annually) to a small percentage of the account total (0.15-0.25% of the contract).
Taken together, it is very easy to exceed a 3.00% annual fee on a variable annuity. I typically see them in the range of 3.25-3.75% and have even seen one as high as 4.35%.
Finally, variable annuities will also contain a “surrender charge”. This is a fee (a very, very high fee) that the owner pays if they want to get rid of the annuity during a certain time, known as the surrender period. Surrender periods usually last 3-6 years.
Conflicts of Interest of interest between the agent and client
Insurance companies pay their agents very handsomely for selling variable annuities. According to The Balance, commissions paid to sellers of variable annuities typically range between 4-7%, a fact often not disclosed to the prospective buyer of these contracts. When this is taken into consideration, it’s no mystery as to why these products receive so much marketing.
Distributions likely won’t be able to receive adjustments for inflation
While payments from variable annuities can increase over time, they very likely will not. This is primarily due to the poor performance and high fees that annuities are notorious for. If the goal of retirement planning is to provide a consistent inflation adjusted income for 30+ years, then this “guarantee” is one of the worst tools for the job.
I tell my clients that the single greatest risk they face as they plan for a 30+ year retirement is inflation. Their cost of living will more than double during retirement, meaning that fixed incomes will only go half as far as they did when they began.
Conclusion
A lot more could be said about variable annuities (and annuities in general), as I’ve barely scratched the surface in this short post. For now, it’s sufficient to say that I believe variable annuities are rarely the right fit for a client, regardless of how “conservative” they are. For those that already have a variable annuity, it’s important that you work with someone who can help you understand it and determine the most effective course of action moving forward. And for those that don’t yet have them, make sure to have an impartial third-party review whatever is being marketed to you to determine if you’re receiving the full story.
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