Variable Annuities Pros and Cons
No investment product has created as much controversy or spawned so much division as the variable annuity. Since its introduction in the early 1980s, it has gone through periods of tremendous popularity and relative neglect. A sizable body of literature, both technical and popular, has examined its virtues and defects. At this point we can enumerate the pros and cons of variable annuities pretty thoroughly.
Simple enumeration doesn’t resolve the debate over the merits of variable annuities. That requires evaluation. Listing pros and cons does provide a convenient reference to aid financial planners and investors in that evaluation.
Variable Annuity Pros
Tax deferral – The ability to defer taxes on an investment is a valuable privilege. Most attention focuses on the higher growth attained when investment gains accumulate free of annual taxation. This is not the only benefit of tax deferral. For example, recent academic studies suggest that asset allocation, rather than active management, is the best tool for maximizing rate of return. Tax deferral allows rebalancing of portfolios without creating a taxable event. Another advantage of tax-deferral is that, in principle, the annuityholder is likely to face lower tax rates in retirement than while working.
Growth orientation and equity-grade returns – Variable annuity subaccounts are designed to imitate mutual funds; this facilitates equity investment and the pursuit of growth and high rates of return.
Consumer-directed investment – The investment program of other annuity types is controlled by the issuing insurance company. Variable annuities allow the consumer to manage his or her own investment, at least to the degree allowed by the choice of subaccounts.
Liability protection – Many states shield proceeds of insurance assets from attachment in litigation, which makes variable annuities an attractive growth investment for business owners and professionals threatened with liability lawsuits.
Some provision for liquidity – Many variable annuities allow annual withdrawals of up to 10% of principal. Waiver of surrender charges for various contingencies, ranging from disability to terminal illness, is also sometimes offered.
Possibility of superior investment performance – Some analysts contend that the deterrents to premature redemptions allow portfolio managers more freedom and lead to superior performance.
No limitation on investment amount – Variable annuityholders do not face the annual contribution limits placed on holders of IRAs, 401(k)s and other tax-advantaged retirement plans.
No minimum required distributions – IRAs require minimum required distributions to begin no later than the holder’s age 70 ½. There is no such requirement for variable annuity distributions.
Option to annuitize – The variable annuityholder can withdraw funds at discretion once distribution commences or, alternatively, convert funds into a life annuity guaranteeing lifelong income. Annuities are the only investment offering a guaranteed income for life.
Avoidance of probate – The death-benefit feature of the variable annuity makes it life insurance. This should enable a beneficiary to inherit variable annuity assets directly, without waiting for probate to clear. An equivalent feature may, or may not, be available with alternative investment products.
Living Benefit riders – In the last decade or so, variable annuities have increasingly offered policies or riders that guarantee levels of yield, income, and withdrawals. These have proved popular. Not too surprisingly, some companies have scaled back or discontinued them in light of the current recession.
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Variable Annuity Cons
High expenses – This is perhaps the biggest knock on variable annuities. Variable annuity subaccounts incur expenses that detract from their annual yield, just like the mutual funds that they mimic. But the insurance company incurs additional expenses in operating the subaccounts and adding insurance features, such as death benefits and guarantees. Total annual expenses may reach 3% or more. Surrender charges and penalties for premature withdrawal threaten to add to the list.
Taxation as ordinary income upon distribution – Unlike mutual fund redemptions, variable annuity investment gains are taxed as ordinary income upon distribution. Since income tax rates currently exceed the long-term capital gains rate of 15%, this wipes out some of the tax-deferral gains of variable annuities.
No step-up in cost basis for heirs – Again unlike mutual funds, variable annuities do not receive a step-up in cost basis to the valuation as of date of death, making them unattractive for estate-planning purposes.
Liquidity limitations – Variable annuities have surrender charges that often run as high as 5-10% in the first two years after purchase, tapering off to 1% in succeeding years. The charges may last for as long as 10 years or, rarely, longer. Premature withdrawals (made prior to the annuityholder’s age 59 ½) incur a 10% tax penalty as well as ordinary income taxes.State taxation – Some states levy excise taxes on variable annuities; these are passed along to annuityholders by the insurance company.
Transaction limitations – Some variable annuities place limits on the number of annual transactions allowed in a variable annuity before transaction charges are imposed.
Variable annuities cannot substitute for life insurance – Although variable annuities usually offer a death benefit, that does not make them a good substitute for a life-insurance policy. Ordinarily, insurance need will greatly exceed the amount available via a variable annuity.
Weighing Variable Annuities’ Pros and Cons
The foregoing lists illustrate the difficulty of reaching a summary verdict on variable annuities. Instead, they must be evaluated in context – either as part of a specific financial plan developed for people with particular needs, preferences and circumstances, or in comparison with a known investment alternative with definite attributes.
Variable annuities rate to be a good choice for middle-aged, growth-oriented investors who have maxed out their tax-advantaged retirement-plan contributions but still have cash available. They can be life-savers for high-earning professionals faced with the ever-present specter of liability loss. These are people for whom the drawbacks of variable annuities are non-existent, small, or dwarfed in comparison to the risks that variable annuities would avoid.
Alternatively, variable annuities rate poorly for young newlyweds with modest incomes and little liquidity, as well as for the risk-averse elderly who need liquidity. These are people for whom variable annuities’ drawbacks loom large relative to their advantages.
Take That Thumb Off the Scales
Many studies have purported to find variable annuities inferior to taxable mutual funds. Unfortunately, the conclusions are typically reached by weighting variable annuities’ disadvantages heavily and dismissing their advantages. For example, the comparison usually pits a low-cost mutual fund (such as an index fund) against a high-cost variable annuity. The consumer would never suspect that mutual funds can also have high costs (international funds are notoriously high), sometimes levy sales loads on purchases, and often impose high fees and their own version of surrender charges (called redemption charges). Why not compare a low-cost variable annuity to a high-cost mutual fund? Somehow this almost never seems to happen.
The sensible approach is to treat variable annuities as a specialty product with very desirable features but drawbacks that may make them unsuitable for certain people and groups. Like medicine, variable annuities can be beneficial and even invaluable for the right customer, but disastrous for the wrong one. One good approach might be to start by studying the list of cons. If these don’t seem too injurious, then proceed to the list of pros with a reasonable expectation that the benefits of variable annuities will exceed their costs.
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