Each week I will post timely information and advice regarding the topics that most impact the folks I meet with each and every day. Some posts will be about specific questions that come up, while others might be about specific investment products I oftentimes review. This first post will be about a very popular financial services product: Variable Annuities (‘VA’ for short). I have met with several people over the last week that have purchased these products from various brokers and insurance companies. I am not going to review a specific product, rather I will walk through some general information that would apply to most Variable Annuities.
This post will help you:
Understand the fees of Variable Annuities
Understand the riders that can be added
Know when to run!
Understand where they are best used
There are usually three or four different fees that are involved in a VA. These fees include, Mortality and Expense Charges, Administration Charges, Subaccount Charges, and Rider Charges if you add an Income Rider or Death Benefit Rider.
The Mortality and Expense charge is usually anywhere from 1%-1.6% per year. This fee goes to the Insurance Company on an annual basis for any risks they may be taking in the contract.
Administration charges go to the Insurance Company to Administer the contract. This fee is sometimes broken out in a percentage at around .15% per year or it could be a dollar amount at $30-$35 per year. Some Insurance Companies will waive the Administration Charges if you have a predetermined amount of money in your contract. Occasionally you will see this fee included in the Mortality and Expense charge.
The Subaccount fees are what you are paying for the actual funds that you own. After all, a Variable Annuity by definition is a product whose value is variable, meaning it can go both up and down. The Insurance Company will sometimes tell you these fees average 1%. You can find the actual expense of the funds in the prospectus of the annuity.
Rider charges can vary greatly. The two riders that are usually added are an Income Rider or a Death Benefit Rider. I will cover what these riders do for you later in this post. The fee for the riders are usually anywhere from .5%-1.5%.
It is critical that you understand what you are paying for these products. As you can clearly see, these fees add up in a hurry. The best way to identify the fees you are paying is to actually call the insurance company that has designed and issued the annuity contract. After all, they are the company that wrote the contract so they should give you the best and most accurate information.
The final fee an annuity contract may charge is the surrender fee. Annuities in general are long-term investment products. This means that they should be utilized only if you are able to defer the principal over a long period of time. Many annuity contracts contain surrender charges for approximately 10 years. This means that, should you completely liquidate your annuity for cash prior to the end of that 10 year period you may be forced to pay a penalty in order toaccess that liquidity. Note that, once the annuity has been held for the entire surrender period. most contracts can be liquidated with no additional ‘liquidity fee’. *NOTE: This is a good reason why you would NOT want to put the majority of your assets into ANY type of annuity (see ‘When to Run’ section).
Riders: What they ARE & what they are NOT
The two riders that are most typically used are Income Riders and Death Benefit Riders. The Income Rider will typically generate a certain amount of income guaranteed for the rest of your life*. These riders come as “Single” or “Joint” payouts. This means they will pay out for either the contract owners lifetime or the contract owner and their spouse’s lifetime. The amount of income will be determined as a percentage of the rider value. *Types of Income Riders will be discussed in a future blog post. For example, if the Income Rider Value is $100,000 and the payout factor is 4%, the annuity will produce $4000 per year in income. This guaranteed income will usually increase the longer you wait to start drawing from it. For example, if you begin receiving income at age 65 the payout might be 4%. However, if you wait until age 70, the payout may go up to 4.5%. It is important to distinguish between the rider value and you actual account value. You will never be able to take the rider value out in a lump sum. This is only a number the Insurance Company uses to figure out how much income you will get. It is a purely hypothetical accounting number. We will touch on this again on the “When to run” section.
In contrast to an income rider, you can also add a death benefit rider to your contract. A death benefit rider may increase your contract’s death benefit by a certain percentage each year. Others will make sure your contract is at least worth what you put in upon death (may be called a Return of Premium rider). Again, it is very important to distinguish between these rider values and your actual account value.
When to run!
This brings us to the “when to run” section. I can’t tell you how many times I have heard people say “I am getting a guaranteed 7%” or “I am investing in the market, but if the market goes down I still get 5%”. Doesn’t this sound too good to be true? If you are working with an advisor that tells you any of this nonsense, run! With rates slowly climbing off all-time lows do you really think there is someone guaranteeing a 7% rate of return? What the advisor isn’t telling you is that the 7% is only on the rider value! It is NOT real money!
When you invest in a variable annuity with an income rider you need to remember that you have two values to account for. The first is the value of your underlying mutual funds. This is what your contract is actually worth. If you were to surrender (liquidate for cash) your contract for any reason, this is the amount of money you will receive minus any surrender charges (assuming you were still in the surrender period). The second account is your rider account. This is the account that grows by the ‘Guaranteed’ increase amount. Remember, this account is ONLY used to determine the amount of income you will receive either now or in the future. It is NEVER a real cash-out walk-away value.
How are they best used?
We never want to make a blanket statement and say all of anything is bad. There are places where variable annuities could be a great fit. For example, one of the biggest reasons people purchase annuities is for tax deferral. The variable annuity can be a great way to invest money in the market and defer the taxes that would otherwise be taxable during that year. Before you make any decision regarding an annuity, be sure to give us a call to request an Annuity Stress Test. This way you can insure that the annuity you are considering purchasing is without a doubt in your best interests.