Personal Finance: Do your homework before buying variable annuities

Personal Finance: Do your homework before buying variable annuities

March 12th, 2014 by Chris Hopkins in Business Diary

Chris Hopkins

Chris Hopkins

Photo by Patrick Smith /Times Free Press.

Few topics stir the pot more than a critique of variable annuities. Caveat editor.

All too often, financial advisors must deal with the fallout from bad advice offered by a purveyor of variable annuities. Having seen another example in our office this week, we thought a refresher course was in order.

Annuities are as old as the Roman Empire, when investors deposited funds into a pool and received in return a promised annual stipend or "annua." This type of arrangement involving a promised constant series of annual payments is called a fixed annuity, and remains a valuable and useful tool for creating a dependable income stream.

Variable annuities, on the other hand, are a relatively recent development, dating back to the early 1950s. These products mingled the concept of an income stream in later years with an at-risk investment vehicle like a mutual fund prior to the onset of the fixed payments. Although seldom optimal and often costly in their modern incarnation, there is nothing inherently wrong with the concept of a variable annuity. The problem with some of these products arises from their cost, complexity, and promotion to people for whom they are clearly inappropriate.

According to the Investment Company Institute, 22 percent of households hold IRA accounts that contain variable annuities, yet there are few cases in which this product is appropriate for a tax-deferred account. The primary benefit of a variable annuity is the tax shelter of the investments. Since this already exists inside the IRA, the proximate justification for the product disappears. Consultant Daniel Solin likens it to wearing a raincoat indoors. It is seldom the right choice for an IRA.

Some salespeople will argue that other features like guaranteed death benefits justify their use in IRAs. But these considerations can easily be addressed (with substantially lower annual costs) by deploying appropriate asset allocation.

Variable annuities are expensive (total fees can easily exceed 3 percent annually with fund expenses). This is in part due to the high compensation for marketing them, with typical commissions of 4 to 8 percent split between the salesperson and the broker. Furthermore, they usually assess significant surrender charges if you change your mind in the early years. And be aware that additional "guarantees" or bonus payments are never free; you pay for them in higher fees. So-called equity-index annuities (or fixed-indexed insurance products) are often the most opaque, frequently carry exceptionally high surrender charges, and are best avoided in almost all situations.

There certainly are cases in which a variable annuity is appropriate, like a high-income investor already maxing out a 401(k), or in certain estate planning scenarios. In most cases, however, there should be a very high bar which is rarely cleared for IRA holders or elderly investors.

FINRA reports that complaints regarding variable annuities exceed those for any other investment product on a relative basis, owing to their complexity and the incidence of aggressive sales tactics. Given the somewhat problematic history of these products, most states require that buyers be given a reasonable period of time to back out.

Before you purchase, ask for an accounting of total compensation to the sales representative and the broker, and a breakdown of the annual fees including fund expenses. If you decide that a variable annuity is the right tool, shop around. Many insurance companies and some brokerages now offer products with no sales loads and no surrender charges that could save you thousands of dollars. And if you are not certain that you understand the details, don't pull the trigger.

Christopher A. Hopkins, CFA, is vice president of Barnett & Co. Investment Advisors.