Beware of the Darling of Variable AnnuitiesSubmitted by Concierge Financial Planning, LLC on July 17th, 2015
“It’s a great investment!” replied Ed when I asked him why he had purchased his variable annuity. “I get 5% guaranteed—and if the markets do better I get all the upside too!” The promise sounds too good to be true. And, in this case, it is too good to be true. I’ve seen this annuity many times over the past few years. The sales pitch is very convincing—who wouldn’t want no downside risk and full upside benefits. Has anyone tried to sell you this annuity?
Basically, Ed invested in an annuity that provides him with a guaranteed minimum withdrawal benefit equal to his initial investment plus 5% per year. Meanwhile, Ed’s actual funds are invested in the mutual funds of his choosing and if his funds perform better than the initial investment growing at 5% per year, he gets that benefit instead. What’s more, if he dies, his spouse, Sue, gets an enhanced death benefit.
Before you ask me where you can get your hands on this miracle investment let me tell you how it actually works.
First, let’s look at the fees, which Ed neglected to mention to me. He pays an astronomical 3.80% of his invested funds per year. Yes, year after year after year. These break down as follows:
1.05% mortality & expense
1.00% guaranteed withdrawal benefit
0.90% mutual fund expense ratio
0.60% enhanced death benefit
0.25% administration fee
That brings his 5% “guarantee” down to a 1.2% return. Talk about a letdown. If we add 2.5% inflation into the calculation, then Ed has a 0% guaranteed return and is losing real purchasing power every day. Inflation would have to be below 1.2% in order for Ed to stay even with his initial investment.
In addition to the guarantee, this annuity promises to pay more than the 5% floor if the mutual funds do better. Doesn’t this make up for the high fees? Not likely. This is because the annuity issuer requires Ed to choose from a series of balanced mutual funds, which are invested 60% in stocks and 40% in bonds. Ed can’t invest in riskier assets like small cap stocks and still have his investment floor; he is limited to a balanced portfolio, which, many experts agree, can be expected to return 6.5% at best. The 6.5% minus the 3.80% fees delivers a paltry 2.7% return—and, with 2/5% inflation, this is more like 0.2%.
Sound like a good investment to you? Not at all. And, to make matters worse, down the road when Ed annuitizes, his guaranteed payments are not adjusted for inflation. This means that he will effectively be receiving a pay cut every year just like a pension without a cost of living adjustment. Ouch!
That’s not all. In case that Ed realizes that he has a made a mistake after purchasing the annuity, the insurance company issuer has a safety feature installed. It’s called the surrender fee. If Ed wants out of his annuity he’ll have to pay a 7% fee, which then decreases annually until it hits 0 after seven years.
Annuities like Ed’s go by many names, but they all offer a guaranteed minimum income or withdrawal benefit. If the annuity you are looking to purchase has this feature, do a very careful reading of the contract and get professional help if necessary before you sign on the dotted line. If you don’t already own an annuity like this, there is a very good chance that someone will try to sell you one as they are simply too lucrative for salesmen to ignore. The truth is that these annuities are always sold and never bought.
My advice: say no, keep your money, and opt for a conservative portfolio of low cost mutual funds or ETFs instead.
Disclosure: I have not described variable annuities with guaranteed benefits in detail. I have just given the broad outlines of one type of annuity. They’re not all bad;)