It seems the older we get, the faster time flies. I can’t believe it’s almost the end of the year.
After being out of the office for more than two weeks, I knew I’d have a bunch of email waiting for me. One email in particular caught my attention. Paul G., (of Queens, NY), who is a referral from an existing client, is considering the purchase of a Variable Annuity (VA) and inquired about the associated cost of the guaranteed insurance benefits of the product.
Over the years I’ve visited with hundreds of clients who have a Variable annuity in their portfolio. This is primarily due to the fact that I have working relationships with a number of Credit Unions whose member base includes public employees, hospital personnel, and school teachers.
The majority of these Credit Union members contribute to a 403(b) retirement savings plan and over 90% of these plans are funded in a Variable Annuity.
Before I get into how the insurance actually works on a VA, I’m going to assume you may not be familiar with VAs. So what do you get when you buy a Variable Annuity? You basically get two things:
- You get an investment in mutual funds that invest in stocks, bonds, money market accounts, or a combination of the three, called a subaccount.
- The subaccount comes with an insurance contract (also known as an “insurance wrapper” with benefit riders) intended to protect you from not losing too much money.
Like Paul G., I’m sure that the majority of people who buy a VA see it as a way to invest in mutual funds in a tax favorable manner, meaning the money can grow tax-deferred without any capital gains and dividend tax, until you start making withdrawals or receiving scheduled payments.
Now on the surface, not paying capital gains sounds like a pretty good deal. But let’s take a look at how much the Variable Annuity buyer will pay for those benefits.
First, you’ll pay an annual management fee of about 1.2% on that subaccount, which is similar to the fee you’d pay on an actively managed mutual fund, and the subaccount may also have a load. You will also pay an annual “mortality and expense (M&E) charge of about 1.3% – 1.8%, which pays for the insurance contract, administrative fees, and part of the advisor’s commission, making a VA almost twice as expensive as the average mutual fund.
The insurance death benefit of a VA works like this. Let’s say you put $250,000 into a Variable Annuity, knowing that your beneficiaries would never receive less than $250,000 from it. If your account lost value (as thousands have over the past decade) your VA may have a value of significantly less than $250,000 when you die. The only way your family will be able to receive that guaranteed $250,000 is as a death benefit when you die.
Yet the cost is anywhere between 2.5% − 3.0% in annual expense fees, and we haven’t even added any guaranteed benefit riders to the product. I mean, what’s the point in purchasing a VA if you’re not going to add any guarantees to the product?
A few years ago, Investopedia published an article by George D. Lambert entitled: “The Cost of Variable Annuity Guarantees” which described the guaranteed riders in detail and the associated cost against your account value. What riders you may ask? Here they are with their potential annual fees:
Guaranteed Death Benefit (GDB) .15% − .35%
Guaranteed Minimum Accumulation Benefit (GMAB) .25% − .75%
Guaranteed Minimum Withdrawal Benefit (GMWB) .40% − .65%
Guaranteed Lifetime Withdrawal Benefit (GLWB) .50% − .60%
Guaranteed Minimum Income Benefit (GMIB) .50% − .75%
Totals: 1.80% – 3.1%
If we add up all the fees and associated guaranteed benefits, what do we have?
The total annual fees and expenses could be between 2.5% – 4.0% or more as you can see… depending on the product and the selected guarantees. It’s pretty clear to see how these immense fees can take a HUGE bite out of performance — enough to completely offset the supposed advantage of the Variable Annuity’s tax-deferred status in many cases. Also, let’s not forget that these riders must be elected when the contract is issued, and in some cases they are non-cancelable, which means their costs continue even if there is no chance they will ever pay off… and ALL these fees are applied even when the account value is decreasing due to market losses.
I do want to point out that I’m not saying that these fees are either good or bad; I’m just trying to explain how they apply to Variable Annuities… but what I seem to come across in talking not only with Paul G., but with clients in general is that most Variable Annuity owners have no idea how high the fees actually are and no idea how those fees negatively affect their “guaranteed” account value and income stream. These fees are buried into the cost of your VA contract and take away from your annual profits. I wonder how many advisors spend time talking with their clients about the fees associated with these accounts?
I would probably say NONE!
Bottom line here according to an article entitled “What’s Wrong with Variable Annuities,” published by Smart Money magazine on August 1, 2010, stated that: Variable Annuities “only make sense for a fraction of the population.”
HOW DOES THE INSURANCE WORK?
I really believe that if you’re considering the purchase of a VA, the question you should be asking yourself is: “Do I really want or need to pay more for insurance?”
This is the question I asked Paul G., in my email reply to him. Do you really want or need to pay more for insurance? In doing his due diligence, Paul asked if the annual cost of the insurance on a VA is competitive with other insurance policies that are not associated with a Variable Annuity.
I’m going to guess that your response to the question about wanting or needing to pay more for insurance is probably NO!
I found it interesting that when Paul G., sent me information on the VA he’s looking to buy, he also included a copy of the Morningstar report on the product. Morningstar is a non-biased third party research organization: they don’t have any hidden agenda. If you subscribe to Morningstar, you have access to its software program to analyze mutual funds, stocks, variable annuities, ETF and separate accounts.
If you were to look at a Morningstar report on a Variable Annuity product, you will notice that it lists subaccount fund fees. Also listed are the insurance fees on the Variable Annuity.
Again, I want to make it clear that there is nothing wrong with fees, and I’m not saying fees are bad… it’s obvious nobody works for free… so fees are part of the program: that’s just the way it works.
As I looked at the copy of the Morningstar report that Paul sent me, I noticed that the insurance fees on the VA he is considering are listed at 1.4% which is multiplied on the total account value. So for example, if the account has $250,000 x 1.4% = $3500.00 in annual insurance fees.
Get your calculator out and work the math with me.
Paul’s account is worth somewhere in the neighborhood of $338,000. So let’s do the math. If Paul was to buy this VA: $338,000 x 1.4% = $4,732.00 in annual insurance fees per year.
So what does the $4,732.00 of annual insurance fees buy you?
The advisor probably told Paul that if his account goes down or he dies, his family or beneficiaries would get what he put in or in some cases the highest amount that the account has been locked in at.
So for example, if Paul’s account is currently at $338,000 and it dropped down to $300,000 the difference is a $38,000 loss (338,000 – 300,000 = 38,000)
If God-forbid something happened to Paul and the account dropped down to $300,000 the insurance company would cover the loss of $38,000 so that his family would get the whole $338,000.
So, is that a good thing or a bad thing?
That’s a good thing – that the insurance company would cover the loss! And that’s what the $4,732.00 of insurance is paying for…it’s paying for $38,000 worth of insurance.
Let me ask you a question:
Do you think paying $4,732.00 per year for $38,000 worth of insurance is cheap or expensive?
It’s EXTREMELY EXPENSIVE isn’t it!
It’s highway robbery. I just heard on the radio… “A 38 year old male can buy $400,000 worth of life insurance for $23.00 a month” – That’s almost half a million dollars for only $23.00 per month… or $276.00 per year (23 x 12 = 276). Okay, it’s cheap because he’s 38 years old and it’s a 20 year term policy.
But what if he’s 68 years of age, and he spends $5,000 per year, how much insurance does he get? I was curious, so I ran a quote for a 68 year-old non-smoker in good health on a Simplified Issue Non-Med Universal Life policy with Living Benefits…and $5,000 per year would buy him $130,000 worth of life insurance. If he purchased a 20 year term, $5,000 per year would buy him $350,000 worth of insurance.
So, paying $4,732.00 a year for only $38,000 of coverage is a bit high regardless of how old you are.
But if you think that’s expensive… hang on to your boots because it gets worse.
The great thing about life insurance is that it’s the single biggest benefit in the U.S. tax code… when you die, the insurance proceeds paid to your family are income tax free. Unfortunately, in a Variable Annuity, the insurance proceeds are taxable, so if Paul passed away, his family would have to pay taxes on the $38,000.
Is that a good thing or is that a bad thing?
If you’re like me, you probably thinking that paying taxes on the insurance proceeds is not a good thing.
But can it get any worse? Unfortunately it can, and it does!
If Paul’s account balance is $338,000 and that’s the highest it’s ever been and I subtract $338,000 how much do I have? $338,000 – $338,000 = 0 (ZERO)
So Paul would be paying $4,732.00 for how much insurance?
He would be paying almost $5,000 per year for ZERO insurance.
Is that crazy or what?
Remember, Paul said he didn’t want or need any more insurance.
Yet, he would be paying almost $5,000.00 per year in insurance fees, for ZERO insurance coverage.
But here is where it goes from worst to ugly.
If Paul’s account balance happens to go up from $338,000 to $400,000 (which would be a good thing), how much more in insurance fees would he have to pay?
Take a look:
He would have to pay $400,000 x 1.4% = $5,600.00 in insurance fees per year… for how much insurance?
Let’s do the math:
$400,000 – $400,000 = 0 (ZERO)
When the account value goes up in a Variable Annuity, they charge you more for ZERO insurance. So now, Paul would be paying even more in annual insurance fees for NO INSURANCE. Do you want to be in a situation where you’re paying $5,600.00 per year for ZERO insurance?
Remember, Paul said he didn’t want or need any more insurance… why would anybody want to pay so much money for so little insurance… and on top of that have the family pay taxes on the money!
Doesn’t make any sense does it?
How many people do you think would step up to the plate and buy a Variable Annuity if they actually knew and really understood how the insurance fees work on a Variable Annuity?
That’s right… NO ONE!
Think about it… if you own a VA and the insurance company had you on the fishhook for expensive insurance… and if they had you on the fishhook for the-more-you-pay-the-less-they-have to pay out… how many people do you think the insurance company wants out in the field selling Variable Annuities?
I don’t have any problem with the mutual funds in the Variable Annuity account… they’re good funds for the most part. But here’s the sad fact: all the funds in the Variable Annuity, Paul could purchase the exact same thing WITHOUT THE INSURANCE and the annual fees that come with it. I wonder if Paul’s advisor told him that.
I would ask, “Why do you think Paul’s advisor wants to sell him expensive insurance?”
But I think you probably already know the answer to that question. Just in case, let me quote Suze Orman:
I think variable annuities exist for one reason only: to make money for the financial advisers who sell them.” (http://money.cnn.com/2008/06/19/pf/Suze_Orman.moneymag/index.htm?postversion=2008061916)
In her book “The Road to Wealth,” Suze answers more than 2000 questions about financial planning. Someone asks the question, “My financial advisor is recommending I buy a Variable Annuity within my retirement account. What should I do?”
Answer: “Get yourself another financial advisor, pronto.”
If you’re looking at a VA for the purpose of creating a guaranteed lifetime income stream, but you’re seriously concerned about the potential of stock market losses and the associated annual expense fees, I have found that a Fixed Indexed Annuity (FIA) strategy with a guaranteed income rider, will outperform the VA every single time (mathematically speaking) because of what I just explained… without any of the market losses.
When it comes to saving and/or investing, it is crucial to have realistic expectations, especially when it comes to your retirement nest egg. It’s important to take prudent steps to protect your life savings. One of the best ways to protect your hard earned money is to make sure you have guaranteed accounts with low fees while still providing you with a reasonable rate of return.
Whether you decide to buy a Variable Annuity or not, you need to have the facts explained to you. I want you to be an informed consumer and have your money last as long as you do.
If you feel this information can be of benefit to others please feel free to share this blog via LinkedIn, Facebook, Google+, and Twitter with share buttons.
If you have any questions or you would like additional information please feel free to contact me. As always, I will do my best to help you in any way I can or lead you in the right direction.
