Do You Know How Much Your Variable Annuity Is Costing You?
Variable annuities were an ideal investment in past decades. Many investors saw an opportunity especially after the stock market crash of 1987. Markets quickly rebounded towards new highs and investors were forced to place their after-tax income into investments that were taxed at regular income tax rates.
Insurance companies saw this as an opportunity to introduce a product with investment features, hence the variable annuity became popular.
Variable annuities make sense when the market is gaining 1000%.
Having a variable annuity during the bull market allowed investors to keep their gains without having to pay taxes, and thus allowing their money to be reinvested.
However, in order for the investor to have access to a high growth potential with their variable annuity, the insurance company would charge a fee. The variable annuity made more sense during the 80’s and 90’s, while today it’s typically more expensive to own than other investments.
We have identified 8 Variable Annuity Warnings that you should be aware of with variable annuities
Warning No 1: You can lose all your money
The most obvious concern we have with variable annuities is that your money is not guaranteed and is exposed to the stock market.
Variable annuities cannot guarantee the deposit you put in, nor can it guarantee the gains along the way.
For a 35 to a 40 year old investor, heavy market losses may not be as big of an issue on their retirement plan. They still have some time for their money to rebound or save more money.
However, for an investor approaching retirement or already retired, stock market downturns can have devastating financial consequences.
Warning No 2: Variable annuities are very expensive to today’s investor.
It’s important that we address the single most important aspect of variable annuity contracts, fees buried within the prospectus.
We have identified the top 10 variable annuity fees that you should be aware of.
The typical prospectus is between 70 to 150 pages in length, and has countless disclosures and terms. It’s no wonder that it can be incredibly difficult to identify and calculate all the fees buried within the contract.
But before we reveal how you can easily calculate the fees within your variable annuity, let’s take a closer look at how variable annuities are sold.
Variable annuity buyers are sold on the idea of buying mutual funds through the insurance company, instead of going right to the source.
The average mutual fund costs .75%, while according to Morningstar, the national average of all variable annuities costs 3.61% with fees ranging as high as above 5%!
Let’s take some time and review the other fees contained within a variable annuity and how you can calculate for yourself how much you are paying.
- The first charge is the M & E fee, which stands for mortality and expense charge have fees that average 1.25% according to the SEC.
- The next type of fee is the general admin fee, which is usually around .15%.
- When you add benefits such as an income rider, death benefits, or long term care; you can expect to pay .6 to 1.9% in additional fees.
- Mutual fund fees inside the contract. The mutual fund subaccount fees range from .5 to as high as 3%.
Unfortunately, if you were to call up the insurance company you may be told you’re only paying less than you actually are paying.
How do I know what I am paying?
The only way to know for sure, is to review your entire prospectus with a fine tooth comb and dig it out of each fee inside of each fund that you’re invested into to calculate exactly how much you’re paying.
The insurance company is only required to tell you over the phone about the M & E, general admin, and income rider fee.
However, if you want to know the mutual fund fees you’re paying, you may be directed to read your prospectus.
You are required to pay the contract fees, regardless of how your variable annuity performs.
What’s most concerning about fees, is that if you lose any of your money you will still be required to pay the contract fees.
Unfortunately, many of the investors we speak to every day, aren’t aware of all the standard fees that they are paying in their variable annuity (ANY annuity for that matter).
Unfortunately, many variable annuity owners are not even aware that they are paying this much in fees.
In addition to the fees, there are other drawbacks to variable annuities that we have identified.
Warning No 3: Variable annuities offer limited investment options.
When you buy a variable annuity, you’re actually buying from a limited selection of mutual funds inside the annuity contract which are NOT guaranteed.
If you were to buy mutual funds directly from many different companies (such as Charles Schwab, TD Ameritrade, Fidelity or Vanguard), you would have virtually unlimited choices.
Your investment options range anywhere from 90 to a few hundred funds to choose from.
The mutual funds within a variable annuity are actually called “proprietary subaccounts”.
Oftentimes the insurance company creates contracts with mutual fund firms to develop a specific mutual fund for their variable annuity contract.
It’s important to understand the devastating impact of fees on your retirement.
portfoliovisualizer.com
Above is a graph charting the performance of the S&P 500 over the last 20 years.
As you can see it’s been a bumpy road. We have charted two trend lines to track the performance of an initial deposit of $100,000 back in 1999.
The orange line represents the value of your $100,000 over the last 20 years with zero fees, while the blue line represents a 4% annual fee.
As you can see there’s approximately a large difference between both lines, due to the huge impact of fees on the money’s compounding growth.
We like to compare the impact of fees to having a heavy trailer behind a bicycle on a cycling trip.
You’ll have the hardest time riding uphill while towing a heavy trailer. Conversely, when you’re going downhill, the heavy trailer will be pushing down faster. It’s no different with your annuity fees.
Fees in your contract restrict the growth of your money when the market goes up, and they push you down even faster when there’s a market decline.
So what can I do now?
So if you own a variable annuity or are being sold one right now, you’ll want to pay close attention to the following:
- What is the Mortality and Expense (M&E) fee?
- What is the administration fee?
- How many subaccounts do I have, and what is the fee for each?
- What is the contract maintenance fee?
- What is the fund operating expense fee?
- What is the turnover fee?
- What is the mutual fund fee?
- What are the transaction fees?
- What are the rider fees?
- How much is the surrender charge fee?
Warning No 4: You can lose all your benefits.
The governing body that regulates variable annuities is the SEC or the Securities and Exchange Commission.
According to the SEC’s 12 page report: “Variable Annuities: What You Should Know”, there are 5 “caution boxes” the first of which indicates that you should consider the financial strength of your variable annuity insurance company because it may affect their ability to pay the benefits that you were sold.
Even though each variable annuity benefit comes with an associated fee, the following “guaranteed” benefits are NOT protected:
- death benefit
- guaranteed minimum income benefit
- long term care benefit
- or amounts you have allocated to a fixed account
So if you look at your policy and it it says guarantee death benefit (GMIB) or guaranteed minimum benefit (MIB), long term care benefits or money you choose to allocate to the fixed account are all NOT protected.
The SEC cautions you to consider the financial strength of the insurance company because what happened in 2008 taught us that no company is too large to fail.
Recently AXA Equitable stripped away their guaranteed death benefits and Hartford Financial recently took away their income benefit.
Hartford was the recipient of TARP money, of the Troubled Asset Relief Program and received the large amount of “bail money”.
If you read the prospectus (350-800 pages long) closely in these variable annuity policies, you’ll discover that there are guaranteed benefits that can be taken away at the discretion of the insurance company.
What’s really troubling about these contracts is the fact that the insurance company does NOT have to become insolvent to bail out on their guaranteed benefits.
Warning No 5: Guaranteed rate of returns are not what they appear.
The income rider has become an increasing popular additional benefit to the variable annuity. The income rider option provides the investor a guaranteed rate, regardless of how the market performs.
For example, let’s say your account will grow by 5-8% every year, guaranteed unless your funds perform better than 5-8%, in which case you would receive the higher of the two values.
When your account reaches a specified high dollar value, your income rider will lock in that new dollar amount.
Based on what we have found, the income rider benefit (from any type of an annuity) has been the most misunderstood feature of the annuity contract.
Some sales agents have misrepresented how the income rider benefit really works, leading to frustrated and unsatisfied clients.
You may have been sold on variable annuities because you were convinced you were getting a 6% guaranteed rate of return, so we can afford to take risk with your money.
The problem is that that the 6% rate of return is really what we call the “funny money” account (more on that later) NOT your actual account balance.
Many annuity owners don’t really understand how their income benefits work because of the way they were sold by their agent.
It’s important to understand that the growth rate associated with the income rider is not really a guaranteed rate of return on the account value (or cash value that you can withdraw).
The income account value, is a dollar amount used by the insurance company to calculate how much income payouts you will receive (along with your age, when you start receiving income and your life expectancy).
Your actual account value that you can withdraw, is NEVER really growing at a guaranteed rate.
We like to use the term “real money” vs “funny money” to help annuity owners understand the difference between the two.
The cash value of your annuity is the dollar amount you would walk away with, should you choose to cash out of your annuity.
The funny money is technically called the “Income Account Value” and is the dollar amount that is being used to determine how much income you will receive.
Keep in mind that income riders are designed for income, and NOT to grow a cash value that you can cash out later down the road.
A lot of financial people are pushing variable annuities hard with a promise of getting a 5-8% per year rate of return.
Are you being told the truth? Well, not exactly. Getting 5-8% is a hypothetical number, or “funny money” because it’s used to calculate an income payout, NOT a real return on your initial deposit that you can cash out.
This is where variable annuities can be misrepresented and investors misled to having the wrong expectations regarding their annuity cash value.
Remember that you can’t guarantee the dollar amount that you have in a variable annuity because it’s prone to the ups and downs of the market while you are paying fees.
Warning No 6: Many variable annuities pay less income than other products and oftentimes DON’T have joint payout.
If your main priority is getting the highest amount of income, we have found other annuities with higher payouts than variable annuities.
Furthermore, many variable annuities don’t provide spousal payout.
If you’re married, how important is it for your spouse to have income if you should pass away?
How important is it for you to know that the income strategy planning you set up with your advisor, is going to leave a legacy to your spouse?
If this is an important benefit for you, you’ll want to compare other types of annuities with your variable annuity.
Fortunately, some insurance companies are catching on and starting to add those joint benefits to their variable annuities.
Warning No 7: You may be penalized if you withdraw your Required Minimum Distribution (RMD) from a variable annuity
We have found this to an unique problem with variable annuities that you typically don’t find with other fixed index products.
With some variable annuities, if you reach into your policy and you to take out one dollar (doesn’t matter how much) the insurance company may penalize you by not giving you your guaranteed rate of return.
We’re referring to the typical 5-8% guaranteed rate of return applied to what we call the funny money account which determines your income payouts.
To make things worse, you still may have to pay your variable annuity fees as usual even though your 5-8% increase was waived.
Warning No 8: You may be required to wait up to 10 years before you can start receiving income payments AND you may have to annuitize your contract.
So what does annuitization really mean?
Annuitization is when you convert the dollar amount you have in your annuity into a series of periodic income payments.
It’s like converting a lump sum dollar balance into a pension.
The benefit to annuitization is that you’ll be receiving regular income payments for life.
Annuitizing your money is an irreversible decision that results in you losing control of your money, which applies to other annuities as well.
Do variable annuities ever make sense today?
Back in the 80’s and 90’s variable annuities were a useful investment tool because it provides the investor the ability to get tax deferral for after-tax income.
However, a lot of variable annuities are being purchased with 401K and IRA money which are tax-deferred vehicles already.
This means that the investor would be paying a fee for a benefit that they already had in the first place.
During the 80’s through the 90’s you could expect to have 30-50% market gains per year, and thus a 5% variable annuity fee wouldn’t have such a dramatic impact as it would today.
There are other low cost alternatives with far superior guarantees that many investors aren’t even aware of.
In summary here’s what you should be aware of with variable annuities:
- Variable annuities have limited investment choices
- Fees can total 4% annually and can go above 5%
- You can lose all your money
- Your guaranteed death benefits, income accounts (funny money), etc are only backed by the insurance company and can be discontinued at their discretion.
- Payouts on funny money accounts are typically lower than other annuities & many contract’s don’t have joint payouts
- You may be penalized if you withdraw your “RMD”
- Some contracts force you to annuitize & WAIT to receive guaranteed income
Keep in mind that every investment vehicles has its pros and cons, and there isn’t any one annuity (or any financial product) that can provide EVERYTHING that you need in your financial plan.
Your advisor needs to help you determine what your goals are in retirement and help you find the right low cost financial products that fit into a sound financial plan.
The bottom line is that every annuity or financial product is typically good at providing certain benefits, and may be somewhat lousy and others.
And when it comes to financial planning for retirement, you need to find a low cost financial option that doesn’t erode into your principal.
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