Financial planners, insurance agents and stockbrokers get a lot of flak from the media for getting their clients to invest in variable annuities for two main reasons: commissions and taxes. Let's take a look at a common investor conversation to see why people often get misguided into investing in these annuities.

Gerald and Ashley were knee-deep in their annual discussion of their finances. Gerald looked at his retirement plan statement again. "Well, it says here that my portfolio is allocated between two Oppenheimer funds, one Franklin fund, one Eaton Vance fund and a Davis fund."

Ashley was unimpressed. "Gerald, if we're invested in all of these different companies, then why is there only one telephone number given to call if we have questions? And why is the number given the number to an insurance company? I thought you said that we were invested in mutual funds!"

"Well, we are invested in mutual funds. That's what our broker told us, anyway!"

A Common Misconception
Gerald and Ashley's hypothetical conversation exemplifies the confusion that many investors experience when they examine their Individual Retirement Accounts (IRAs), or other retirement plan investments. Planners, brokers and agents have been investing their clients' retirement money into variable annuities for decades, and while this practice has become commonplace, it has also been the target of criticism by some who claim that those who use this strategy are motivated primarily by commissions. This is because financial planners are fully aware that straight mutual fund investments almost always pay smaller commissions than annuities of any kind. (For background on annuity investments, read An Overview Of Annuities.)

Disparity in Commissions
Breakpoint reductions in mutual fund commissions only serve to widen this gap. For example, a client that rolls a $500,000 401(k) into an IRA and invests the entire balance in Franklin funds will only pay a collective sales charge of 2%. Most fixed or variable annuities, however, pay commissions ranging anywhere from 5-7%, or even higher in some cases. Therefore, a $500,000 IRA rollover into Franklin funds would pay the planner a $10,000 commission at most, while the same rollover into a variable annuity offering Franklin funds could easily pay the planner anywhere from $25,000 to $35,000 in gross commission. Consequently, many planners will simply direct their clients into an annuity with little or no discussion about the differences in fees or sales charge structure.

Because most variable annuities do not assess front-end sales charges, they may appear to be no-load investments to uneducated clients. Of course, variable annuities do have fees and expenses that must be considered. Most variable contracts have five- to seven-year back-end surrender charge schedules similar to B-shares in mutual funds. The majority of these contracts make up for this by assessing annual maintenance and operational charges that often end up being more expensive in the long run than A-share mutual funds. But planners who work with long-term investors can easily gloss over this issue during the sales presentation. (For more insight, read Variable Annuity Benefits: What The Fine Print Won't Tell You and Getting The Whole Story On Variable Annuities.)

No Added Tax Deferred Benefit
Another more pressing and straightforward issue is that of tax deferral. Because IRAs and other retirement accounts already grow tax-deferred, no further tax advantage of any kind can be achieved by investing the money inside them into variable annuities. This is why so many advisors suggest maxing out IRA and 401(k) contributions first, then funding annuities - preferably in a taxable account so that more of your money is growing tax deferred.

The Case for Variable Annuities
Insurance Feature Can Provide Peace of Mind
Despite the criticisms listed above, many financial planners strongly advocate investing their clients' assets in annuities for a number of reasons. One of the main advantages that annuities can provide is a measure of insurance protection for the contract value. Variable annuity proponents argue that clients should insure their retirement plans the same way that they insure all of their other major assets. Because they would never think of owning a house or car without insurance, why risk a retirement plan?

Riders Can Provide Guarantees
The living and death benefit riders offered within most variable contracts today can provide critical principal protection for investors who may still need equity exposure in their retirement portfolios in order to achieve their goals.

For example, the guaranteed minimum income benefit rider that many variable annuities offer provides a guaranteed payout at a specified rate of growth, regardless of the actual performance of the underlying mutual fund subaccounts. Therefore, a client who invests $500,000 in a variable annuity and opts for this rider can enjoy a guaranteed hypothetical growth rate of 7%, and then a guaranteed stream of income. Furthermore, the income streams received by contract holders will usually also satisfy their minimum distribution requirements (MRDs). Other riders can periodically lock in the contract value and guarantee that the client will never receive less than that value out of the contract, even if the actual market value of underlying funds were to decline substantially. Of course, these riders come at a price, but many planners feel that the cost is justified, particularly with older clients who won't have time to recoup market losses.

Auto-Pilot Management
Protection riders are not the only advantage cited by variable advocates. Variable annuities contain a number of professional money management features, such as dollar-cost averaging, value averaging, periodic portfolio rebalancing and a wide selection of funds and fund families to choose from. (To read more about insurance riders, see Let Life Insurance Riders Drive Your Coverage.)

A Possible Solution
While there is a fair amount of gray area in this matter, one alternative for planners is to allocate their clients' retirement portfolios in straight mutual funds before retirement, and then move their account values into variable contracts once they stop working. This approach could allow for more streamlined growth before retirement, and then provide continued growth with downside protection during the client's later years. Once the main income earner has stopped working, capital preservation becomes a primary goal because there will be nothing else to replace primary cash flows. If you're concerned about the drawbacks of investing in variable annuities, you could broach this strategy with your advisor.

In the final analysis, there may be no real right or wrong in this issue. The only real requirement that planners must satisfy is ensuring that their clients understand the costs (both real and opportunity costs), fees and risks involved in their investments, whether they are annuities, mutual funds or any other vehicle. Annuities from traditional low-cost providers are increasingly offering very low annual expense ratios for key rates like the mortality expense and management fees.

At the end of the day, financial planners will likely have to examine this issue on a case-by-case basis to determine whether variable annuities are appropriate for their clients.

Related Articles
  1. Retirement

    Is Working Longer A Viable Retirement Plan?

    Fully funding someone’s life for three decades without work is tricky. The result is retirement has become, for many, a 30-year adventure.
  2. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  3. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  4. Personal Finance

    How the Social Security Reboot May Affect You

    While there’s still potential for some “tweaking” around your Social Security retirement benefits, I’d like to share some insight on what we know now.
  5. Retirement

    Read This Before You Retire in the Philippines

    The Philippines has a warm climate, a low cost of living and plenty of people who speak English. What to do next if you think you want to retire there.
  6. Retirement

    4 Books Every Retiree Should Read

    Learn more about the current financial situations retirees are facing and discover four books that every prospective and current retiree must read.
  7. Retirement

    Retirement Tips for Doctors

    Learn five tips that can help physicians get back on schedule in terms of making financial preparations they need to retire.
  8. Investing Basics

    Do You Need More Than One Financial Advisor?

    Using more than one financial advisor for money management has its pros and cons.
  9. Retirement

    Should Social Security Be Privatized?

    The idea of controlling your own retirement money is one that continues to hold appeal for a large segment of voters.
  10. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  1. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  2. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  3. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
  4. Are catch-up contributions included in the 415 limit?

    Unlike regular employee deferrals, catch-up contributions are not included in the 415 limit. While there is an annual limit ... Read Full Answer >>
  5. Can catch-up contributions be matched?

    Depending on the terms of your plan, catch-up contributions you make to 401(k)s or other qualified retirement savings plans ... Read Full Answer >>
  6. Are catch-up contributions included in actual deferral percentage (ADP) testing?

    Though the Internal Revenue Service (IRS) carefully scrutinizes the contributions of highly compensated employees (HCEs) ... Read Full Answer >>

You May Also Like

Trading Center