Of all the types of annuities available, variable annuities seem to be the most maligned, controversial and yet popular in some quarters. They have been in the spotlight recently because of the actions of annuity sellers. Inadequate disclosure, churning and inappropriate sales are some causes of the problems associated with variable annuities.
A variable annuity is an insurance contract that facilitates investments in moderate to high-risk mutual funds, often with no minimum guarantees. It combines the characteristics of an annuity with those of risky mutual funds. This is the root of the problem with variable annuities. The following are the branches:
1) The annuity may not perform as expected
Variable annuity quotes often use projected rates. Often, it is the case that actually performance falls short of planned performance. This happens because projected rates are often exaggerated and the performance of portfolios associated with variable annuities is susceptible to market proclivities.
2) Tax treatment
If you invest in mutual funds, your returns would be subject to capital gains tax. While tax breaks are offered on deferred variable annuities, the returns are taxable during the payout phase. The tax that would apply to returns from variable annuities would be income tax. Income tax is much higher than capital gains tax, so the returns from a variable annuity would be undermined by taxation.
3) Surrender charges or withdrawal penalties
Annuities usually have penalties for withdrawal (about 10%) before the age fifty-nine and a half. Insurance companies may also levy their own surrender charges against the cash value if any withdrawals are made before a certain number of years. In some cases, surrender charge periods may last up to 15 years. The only bright spot is that they may be as short as 6 years.
4) Investment fees and charges
Mutual funds usually have charges and fees associated with them. The portfolios associated with variable annuities are no different. The fees associated with the variable annuity erode the returns from it. It may take as much as one or two decades of having a variable annuity for the returns to significantly outweigh the investment charges. Variable annuities may also include added expenses for living benefits and other provisions that the insurer may opt to offer.
5) Death benefits
As an insurance contract, the annuity facilitates the transfer of the cash-value to beneficiaries upon death of the annuitant. However, the cash-value would be taxable. This is primarily because the death benefit would be treated as a withdrawal.
6) Unnecessary additional benefits
Variable annuities may consist of insurance benefits that may be superfluous. Due to the other expenses associated with variable annuities, taking extra benefits on it that may not even be used are not cost effective. Variable annuities are touted as vehicles that can yield tax breaks and provide protection from creditors and lawsuits. However, there are better means of doing this. IRAs and 401(k)s are better means of obtained tax breaks. Increasing liability protection on your auto insurance or homeowner’s insurance is a much more effective way to guard against public liabilities.
Variable annuities benefit annuity sellers more than the clients. Annuities investors might like the guarantees that are provided as optional benefits on some variable annuities, but this is a peripheral issue. Those who invest on their own can safely manage the risks they take on investment by properly diversifying their portfolio. Although the sales of variable annuities are on the rise, it is not an indicator of its value. Variable annuities should be viewed as a last resort. Even if it is the last resort, it should be considered only if the terms of a particular plan are favourable.