The Pros and Many Cons of Variable Annuities

— -- If you’re middle-aged or older, there’s a good chance that a financial services company will contact you about a variable annuity. These highly complex products are often said to be sold, not bought.

Annuities are basically the opposite of life insurance. With life insurance, you pay periodic premiums, and your beneficiaries receive a lump sum when you die. With annuities, also offered by insurance companies, you invest a large lump sum up front to get growth and protections on your investment.

Variable annuities are opportunities to invest in subaccounts that are essentially clones of mutual funds. With any annuity, the idea is to ultimately access the growth of your investment or pass it on to your heirs. The amount of growth -- and how and when you can access your money -- depends on the terms of contracts that can run hundreds of pages.

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Upsides include:

• Tax deferral. Taxes on annuity earnings are deferred until you take money out. This provides additional tax deferral for people who are already at the limit on their contributions to IRAs or 401(k) plans.
• The eventual opportunity to convert the investment to a lifetime income stream. If chosen, the certainty of this income has appeal for those who are concerned that they might outlive their other retirement resources.
• In some states, protection against court judgments. This can be an attractive feature for people with delinquent debt or physicians who may be personal targets for malpractice lawsuits where insurance doesn’t completely cover damages.

Downsides include:

• Complexity. It’s extremely difficult to determine what you’re buying and exactly how much it’s costing you – and to assess how this plays into your life situation.
• Fees that are often high. With bells and whistles added, some variable annuities carry embedded fees of as much as 4 percent a year.
• Variable and other types of annuities are generally illiquid investments – you can’t get at the money quickly. And there’s often an initial several-year lock-up period when you can’t access your money without paying a huge penalty. This is because the company is slowly recouping high sales commissions through annual expenses.

Growth guarantees offered by some variable annuities can be highly attractive for some, including doomsayers who believe the market will crash and stay down. But to get these guarantees, you generally have to pay higher fees. For those who want an annuity but are concerned about the risk that the company holding their annuity will go under, variable annuities can be a good choice over other types because investors retain ownership, though not complete control, of subaccount assets.

For most people, the prospect of buying a variable annuity involves consideration of the alternative: net returns from investing the money in financial markets directly. This way, there’s no lockup period but there are no growth guarantees, either.

As most people never convert their annuities to an income stream, the so-called death benefit is critical for them. Some contracts offer insurance that guarantees that your heirs will receive whichever is greater -- the account value at the time or your initial investment, less any withdrawals. Others only guarantee that heirs will receive the account value. Which scenario is covered can make a huge difference in your estate, so it’s important to discern this difference. Some annuities may offer enhanced death benefits for additional fees. “Death benefit” also refers to what your heirs would get if you die within a certain interval after choosing to take the income stream.

Variable annuities may be right for some people, but this all depends on how the contracts are set up. The driving force behind the sale of some annuities is high commissions – in some cases, about 6 percent. So if someone buys a $500,000 annuity, the seller would earn $30,000 in one fell swoop. If you’re considering an annuity, challenge the seller to demonstrate why the product is right for you and your situation. Typically, these presentations stress growth guarantees, so it’s good to compare these guarantees, net of their cost, to long-term stock and bond market averages.

Before you think seriously about buying, it’s a good idea to hire a qualified fiduciary adviser (one who doesn’t sell products) to review the contract and render an opinion on whether it suits your situation and long-term goals. Some advisers will do this for an hourly fee, and may be able to offer you a less expensive variable annuity with no sales commission.

If you make an informed decision that an annuity is right for you and you’re certain you understand the contract, it’s generally a good idea to limit your investment to about 25 percent of your total portfolio. That way, you’ll retain some flexibility through access to more liquid assets.

Any opinions expressed in this column are solely those of the authors.

Jamie Cornehlsen and Ted Schwartz are advisors with Capstone Investment Financial Group in Colorado Springs, Colo. Cornehlsen is also president of Dunn Warren Investment Advisors in Greenwood Village, Colo. A Certified Financial Planner®, Schwartz advises individuals and endowments. He holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com. Cornehlsen, a Chartered Financial Analyst®, advises business owners and employees on retirement plans. He holds a B.A. from the University of Colorado and an M.B.A. from the William E. Simon School of Business at the University of Rochester. He can be reached at jcornehlsen@capstoneinvest.com.