Variable Annuities: Are They Worth A Look?

For the most part, annuities of any sort have long been on the list of areas to avoid for most folks. These accounts are typically way over-priced for the situation that they are sold to serve, and quite often annuities are only sold to benefit the agent who sold them.

Some recent new activity in the insurance industry has developed an interesting new category of annuities, specifically Variable Annuities (VAs), that gives us reason to re-consider the use of annuities as a possible portion of our retirement portfolios.

So what’s different? Some insurance companies have been listening to the issues that folks have with VAs – the biggest problem being the exorbitant cost of the insurance component – and have introduced new “flat fee” VA, which addresses some of the problems there.

But first, let’s examine the problem.

The Problem With VAs
VAs represent approximately $1.2 trillion worth of Americans’ portfolios. Typically, the average insurance fee is approximately 1.35% on these accounts, which stacks up to approximately $15 billion each year in insurance fees alone. When you add in asset-based fees for the complicated riders, the costs in these accounts quickly escalate.

Many consumer advocates, including the likes of Suze Orman, Jonathan Clements, and Jane Bryant Quinn, have come out against VAs due to the extreme cost issues. To quote Orman “Actually, I don’t dislike VAs, I hate them. Here’s why: they are really expensive… You are pushing 3% a year in various fees. That’s ridiculous.” Leave it to Suze to not mince words.
Mr. Clements, in the Wall Street Journal a couple of years ago, wrote “Variable annuities are a favorite with unscrupulous investment advisers, who can collect ridiculously high commissions by foisting these turkeys onto unsuspecting investors.” As a result, according to the NASD in July of this year, annuity cases are consistently the third most common type of securities arbitration, behind stock and mutual funds.

Flat-Fee VAs
The Flat-Fee VA is a new product that seeks to address these problems by eliminating the percentage rate of insurance costs. These products also eliminate the commissions and surrender charges that were the primary cause of their popularity among the insurance agents that pushed them so hard.

As with all VAs, the new Flat-Fee VA still has some internal costs for the underlying funds, but the insurance component is a simple flat fee – which can be as low as $20 per month, or $240 per year.

If you had a $100,000 account, under the old type of VA with an average insurance cost of 1.35%, you would pay approximately $1,350 for the insurance. In a $1 million VA, the cost for insurance is $13,500. This is reduced dramatically with the flat fee product, which keeps the cost down, sometimes as low as $20 per month. In addition to the flat fee, these new VAs don’t have all of the complicated (expensive!) riders that the old product had. Instead, the products typically have a much more broad array of investment options, helping you to maximize your portfolio performance with alternatives like commodities, real estate, and hedge funds.

So, when might a VA make sense? When you are looking for a guaranteed (more or less*) stream of income, and you’ve maxed out all of your other tax-deferral options. With the elimination of many of our pension plans, and the future of Social Security in doubt, you may want to place a portion of your portfolio in a VA to help ensure that you have an additional tax-deferred component to utilize.

If you’ve been following my advice so far, this will make a great deal of sense to you. I’ll recap briefly how your tax-deferrals should go:

Let’s say you’re over age 50, and you have enough investible income to max out all of your options. The first money should go to your employer’s 401(k) (or other deferred instrument such as a 457, 403(b), or deferred comp) plan, investing up to the employer’s match. Secondly, you should max out your (and your spouse’s) Roth IRA – at $5,000 including the catch-up provision. The next money goes back to your deferred plan at your employer, maxing this out at $20,000 (with the catch-ups included).

For a married couple, this can amount to $50,000 in deferred money, not including the company match (if there is one). If the math eludes you, it’s like this: $15,000 each in standard 401(k) contributions, $5,000 each in 401(k) catch-up contributions, and $5,000 in Roth IRA contributions each, for a total of $50,000.

If you still have money that you’d like to defer for the year, this is when you should consider a flat-fee VA. The money that goes into the VA is taxed at your ordinary income rate, but then you can defer taxation on growth until you begin withdrawing the funds later. And when you begin withdrawing funds, you are only taxed on the gains in the account, making this a fairly tax efficient alternative that you should consider at this stage.

*I mentioned that VAs are somewhat guaranteed. Depending upon the structure of the policy, there is quite often some down-side protection, meaning that you are (for these policies) protected against losing the money that you have contributed to the account. Depending upon the investment options you choose, there could be a high degree of risk involved, so you’ll want to be very careful with these investments and consider the impact to your overall risk profile.