Variable Annuities Punish Returns, Taxes and Heirs

PHOTO: Variable annuities arent sold by carnival barkers, but theres definitely salesmanship involved.

In these days of low bond yields, many people are looking for easy, set-it-and-forget-it investments to generate income. Stepping aggressively into this itchy market are insurance companies and their salesmen, extolling the supposed benefits of the variable annuities (VAs) they offer.

This type of annuity provides indirect investment in stock mutual funds. Yet this investment, long widely criticized by consumer-minded experts, is no better than it used to be. It ties up your capital, deprives your heirs (compared with direct market investment) and has major tax disadvantages.

Last month, Carlo DiFlorio, chief risk officer of the Financial Industry Regulatory Authority, said that VAs remain “one of the top products for consumer complaints,” many of them involving disclosure and sales practices.

This is hardly surprising, considering the consumerist adage accurately long assigned to these products: They are sold, not bought. If you’re middle-aged or older, and have a pulse and any accumulated wealth, there’s a good chance that someone’s tried to sell you a VA. The reason they try so hard to sell to you is that they earn huge commissions — from 5 to 8 percent — which would mean up to $40,000 for an afternoon’s work selling you a $500,000 annuity.

The idea is that you invest a lump sum that, in turn, the insurance company holding the annuity then invests in mutual funds, and your investment accumulates returns from these funds. At the end of the accumulation stage, the insurer guarantees a minimum payment and after that remaining income payments vary based on the performance of the stocks and bonds in the underlying portfolio.

Sometimes these salespeople tell investors that no commissions are involved. What they’re omitting is that they earn a big commission that comes from not from you directly, but from the insurance company. The insurer needs to recoup the sales commission out of the returns on your invested capital, so there’s a lock-up or accumulation period (usually five to seven years) during which investors pay a high penalty for early withdrawal.

And what about the net returns you get from your lump-sum investment (not the ones your money earns, but those that you get to keep)? They’re generally not good, compared to those you could get from investing in the market directly. And even if the returns were good, these investments would still carry so many downsides that it’s easy to make the case that this is the worst way to invest in the stock market. Among the disadvantages:

* High taxes for you or your heirs. VAs are marketed as being tax-deferred, but so are most other investments, including individual stocks, directly purchased mutual funds and exchange-traded funds, as long as you don’t cash them in. But when you cash in an annuity, you get hit with ordinary income tax (the top rate is now roughly 40 percent), as opposed to the maximum capital gains rate of 20 percent that you’d pay on these other investments. If you die, your heirs would pay ordinary income tax on the gain from the time you bought the annuity — on top of any estate tax.

* High costs. Insurance companies holding these investments charge annual administration fees of 2 to 4 percent. So it’s ironic that people currently seeking yield would be so motivated to buy a VA.

* Limited liquidity. This is an extremely long-term investment that either ties up a huge amount of your accumulated wealth or socks you with early withdrawal penalties.

* Company risk. All too often, investors who buy any kind of annuity invest far too large a slice of their total wealth, increasing the risk of losing principal or potential returns if the insurance company founders. Many used to consider this risk to be minimal before the problems of AIG, the insurance behemoth that nearly foundered in the financial crisis of 2008-09 under the weight of worthless derivatives before the U.S. government bailed it out.

Then there are VAs’ relatively low returns. Various studies have shown that direct investment in stocks tends to deliver far higher returns without any of the other downsides.

A good way to beat VA returns with low long-term risk is to invest in stocks that regularly pay dividends. These regular payments to stockholders -- paid by mature, low-risk companies based on earnings -- account for more than 40 percent of total market returns over the past 80 years, with dividends from the S&P 500 outpacing inflation by 100 percent. Since 2010, annual S&P 500 dividends have been eight times annual inflation. As many companies are sitting on significant amounts of cash they aren’t using because of sustained low consumer demand, dividends are expected to increase nearly 10 percent this year. In effect, instead of investing this money in increased production, they’re paying some of it out to shareholders. By contrast, many VAs are sold with an effective guaranteed minimum return of 5 percent.

Of course, it’s easy to make this kind of minimal guarantee when the insurance company is investing your money in the market for long time periods, because over decades, it’s highly unlikely that diversified stock portfolios will lose money, either. So the real issue is: How much is an annuity going to cost you in terms of missed opportunities to invest a huge tranche of your wealth elsewhere? After all, we’re talking about decades, not years.

These guaranteed rates are based on market performance. The problem is that there’s often a reset on the measurement of market performance every quarter, which over time can slice into your returns. Years-long rolling measurement periods would usually mean much higher contingent returns.

So, in return for this guarantee, investors are actually paying quite a bit. (This is consistent with the reality that whenever there’s a guarantee, there’s usually a cost involved.)

What’s more, the rate guarantees usually only last until you either die or annuitize — that is, convert the assets of your annuity into a series of regular payments. Fewer than 1 percent of all annuities are annuitized.

And many are eventually folded into — what else? — a new annuity with a new commission that investors again indirectly pay for. Salespeople tend to call about the time the penalty period on the existing VA expires.

This call would be your opportunity to make the same mistake a second time by buying another annuity. You can avoid this by not getting a VA in the first place.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.

Any opinions expressed are solely those of the author and not of ABC News.

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