You are looking to build your own pension plan with your hard earned money? Some advisers may talk to you about variable annuities. A variable annuity is an investment product where you accumulate your next egg in a tax deferred structure. At the time of withdrawal, you are allowed to buy an annuity generating a steady stream of income.
Variable Annuities Structure
Variable annuities are nothing like fixed annuities. The value of payments you will receive at retirement is unknown and not guaranteed. In a variable annuity, the investor selects with the help of his rep a series of mutual funds into sub-accounts. The investment risk can range widely from conservative to aggressive portfolio. The money is then invested in those sub-accounts through mutual funds during the accumulation phase.
The accumulation phase is defined by the moment where you purchase your variable annuity contract and open you sub-accounts until the moment you start withdrawing. During that phase, you have the opportunity to contribute to your policy at any time with different amounts. Most likely, you will be suggested to invest a lump sum or periodically if you are building your savings.
The money is invested in mutual funds and this is why the investment returns vary greatly. The amount available for distribution at retirement is unknown as investments are not guaranteed. Therefore, it is similar to a defined contribution pension plan; you know how much you invest in it, but you don’t know how much you will get in return.
How is it Different from Indexed Annuities?
If you look at the indexed annuity structure, you will notice that there are two parts in the contract: a fixed annuity + call options on an index. This structure guarantees you a minimum payment from your annuity.
In the case of a variable annuity, there are no minimum payments guaranteed. Your future annuity payments will depend on how you invest your money during the accumulation phase. You can now understand how different the variable annuity is from the indexed contract. An investor seeking for guarantees should not consider variable annuities as a safe investment.
All after-tax money used to fund subaccounts will benefit from a tax deferral until you start your withdrawing period. This enables you postpone taxed paid on interest and dividend revenues which are usually paid the same year they are declared.
Annual Bonuses & Accumulation Phase
Some contract will add a bonus the investor’s contribution to the variable annuity. For example, for each an investor is in a variable annuity contract, he will receive a bonus on the future annuity value of 5%. The bonus is not real cash (e.g. you cannot withdraw this amount if you cash your policy) but it is calculated at the time of converting your investment in an annuity.
Consider an investor who buys a $100,000 variable annuity contract. The money is then invested in mutual funds for ten years and he doesn’t generate any returns (let’s assume he is very unlucky). If the investor receives a bonus of 5% per year based on his original amount, in ten years, the annuity will be calculated based on an amount of $150,000 even if his sub-accounts generated a 0% return. If the investor wanted to cash his investment and walk away after ten year, he would only cash his $100,000. However, if he stays and decides to take the annuity, the amount of the distribution will be calculated based his investments + his bonus of $50,000.
Capital Protection Option
Most contracts will protect the capital invested upon death. This means that if an investor dies during the accumulation period and mutual funds are showing negative returns, the Life Insurance Company will write a cheque to the Estate in the amount of the capital invested and not the current market value.
Locked-in Market Phase Option
In addition to potential bonuses offered by the Life Insurance Company, some contracts will allow the investor to “lock-in” the market value of his investments at a very specific moment during the contract. This enables the investor of capturing the peak value of his investments for his future annuity calculation even if mutual funds drop later on.
Consider an investor who buys a $100,000 variable annuity contract. After three years of gains on the stock market, the sub-account value is showing $150,000. The Life Insurance Company locks the value of his investment at that number. If the following year the market enters in a recession and mutual funds drop to $125,000 and the investor starts receiving his annuity; the payment will still be calculated on the amount of $150,000é
You can imagine that with those “sizeable” advantages come “sizeable” costs as well. If you are getting excited about variable annuities, you want to read the following. It gives you a clear picture of what variable annuities truly are.
High Management Fees on Mutual Funds
Management Fees (also called MER’s) charged on subaccounts are substantially high. It starts around 2% but could reach up to 4% of your asset. It is definitely hard to show competitive net investment return when you start with an average MER fee of 3%. Therefore, most investments found in variable annuities are underperforming compared to similar portfolio outside such contract. Make sure to enquire about all fees before you purchase such contract.
Similar to indexed annuities, surrender fees are often locked with a minimum of ten years. Therefore, once you sign-up the contract, don’t think about taking your money out of the subaccounts! There are not really any flexibility with variable annuities contracts. Once you purchase a variable annuity, you are also locked-in.
Misleading Usage of the Term Insurance
When a rep use the term “insurance” to be part of a variable annuity, he refers to the fact that you are guaranteed to receive at least the amount you invested from the contract if you die prematurely. This is not a life insurance per se. You only have the “assurance” you will get your money back if you pass away and your mutual funds are currently showing negative returns.
Final Thoughts on Variable Annuities
Personally, I’m not a big fan of variable annuities mainly because they cost too much to structure and they are not flexible. The marketing around those investment solutions are quite phenomenal, but the end result is deceiving. Ask your adviser to show you the difference in term of fees and investment return with a similar portfolio that is not included in a variable annuity contract. You will see him skating for a while…
Guess who truly likes variable annuities? Your adviser making a healthy 3-4% commission by selling them! Imagine if you are about to invest $300,000; this means at least $9,000 in your rep’s pocket. This is enough to push the sale a little, don’t’ you think? When a product is pushed down through your throat, maybe you should simply turn around and walk away…