Variable Annuities are a controversial topic for investing. They have good points. There are also some bad points. It’s hard to know if they’re right for you without an analysis. Below is an article discussing the pros and cons of variable annuities and annuities in general.
Variable Annuities
If you search for the definition of a variable annuity, the first search results will all be from websites of companies that sell variable annuities. So the information is a little biased. But according to investor.gov
A variable annuity is a contract between you and an insurance company. It serves as an investment account that may grow on a tax-deferred basis and includes certain insurance features, such as the ability to turn your account into a stream of periodic payments. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.
The page goes on to talk about the investment feature of variable annuities, but then, in bold, italic print, says:
Keep in mind that you will pay extra for the features offered by variable annuities.
Therein lies the rub. You’ll pay extra. That’s what you hear so little of. Here’s my take on variable annuities.
My Take
In general, you never want to use IRA money for a variable annuity because the IRA already has one of the best features of the annuity – tax deferral. The other main feature of a variable annuity is that it invests in mutual fund-like products wrapped inside the annuity. That to me screams added costs. You’re better off investing in mutual funds outside an annuity to avoid the costs.
So what is it about an annuity that would make you want to buy one? Guaranteed income. The ability to have a guaranteed income is, in my opinion, the only reason to buy an annuity. Because guaranteed income shifts retirement income risk away from the stock market risk and onto an annuity company. So I guess you should validate the strength of the annuity company. Say hello AIG.
My Experience
Of all the annuities I’ve run across in the last 30 years, I’ve only seen one person set up a guaranteed income. It was a 10-year income stream to bridge the gap between retirement and Social Security. It worked well.
Except for that one, I’ve never had a client with an annuity lock-in, the guaranteed income. They just don’t want to give up the money. When you lock in guaranteed income, you essentially buy a contract and no longer have the money. The client who set up a guaranteed income for 10 years kept having me add it to his net worth at our meetings, even though the annuity was not an asset.
I should point out that all the annuities my clients have owned were purchased before they worked with me. When I helped invest them, we used no-load, commission-free annuities with low fees. Those are the only annuities I’d ever recommend. And I’d only recommend them to replace a high-cost annuity. I’ve never suggested someone start a variable annuity with new money. So if you’ve already bought a variable annuity, find a fee-only advisor who will run some figures for you.
Okay Annuities
There are some okay annuities. I’m talking about SPIAs and QLACs. Last year, some colleagues and I took a deep dive into SPIAs (single-premium immediate annuities) and QLACs (qualified longevity annuity contracts). We all did retirement plans with and without SPIAs and QLACs. To my surprise, in my case, the plan with a SPIA was the winner over plans without it. The probability of success increased when you shifted risk from markets to an annuity company. Just as diversifying investment portfolios reduces systematic market risk, SPIAs diversify retirement income risks.
Wade Pfau has done extensive research on how annuities benefit retirement planning. If you’d like to learn more, I’d suggest you start with his research.
You might be wondering, what is a SPIA, and what is a QLAC?
SPIA
An SPIA is a single premium immediate annuity. It’s where you take some money and give it to an insurance company in exchange for a guaranteed income stream. For example, you give them $1 million dollars and get $60,000 income for the rest of your life.
It’s not even listed on investor.gov. The only sites are those that sell them. I’ve never heard of a client being suggested a SPIA. I suggested a client buy a $750,000 SPIA because, when added to their Social Security, it covered their high spending levels and increased their likelihood of success. But they were unwilling to use so much money for fear of having to live off a fixed income. Another rub.
QLAC
According to investor.gov:
A longevity annuity is a type of fixed annuity. It is often sold to investors around retirement age as a way to protect against outliving their retirement savings. In a longevity annuity contract, the investor pays a large amount up front (e.g., $100,000 or more). In return, the insurance company guarantees a specific monthly payout for life beginning at a future chosen date or age (e.g., age 85). After purchase, the investor cannot access the amount they invested to purchase the contract, and will only receive the contract’s guarantee if they are alive on the payout start date. In addition, if the investor dies before their payouts begin, their beneficiary gets nothing, unless the investor purchased an optional death benefit. Because an investor in a longevity annuity gives up access to their up-front payment, delays income payouts, and foregoes a death benefit (if they don’t purchase an optional one), the investor may receive higher payouts than if they purchased a traditional immediate annuity. Under certain longevity annuity contracts, if the investor changes the payout start date, the insurance company could significantly lower the payout amount. One common type of longevity annuity is a qualified longevity annuity contract (QLAC). A QLAC meets certain IRS requirements and must be purchased with money from a retirement account, such as a 401(k) or IRA. Longevity annuities are sometimes also called deferred income annuities or longevity insurance.
QLACs are usually rejected unless someone has way more money than they need. Giving up $100,000 for the guarantee of income when they’re 85 is not a problem.
A Good Option
In my research with clients, SPIAs ended up being a good option because you could make a single premium payment and receive a guaranteed income stream (by the insurance company) to cover basic expenses. This allowed other nest-egg money to be invested more aggressively to take advantage of market growth, and retirement risk to be diversified into an insurance company. But because I suggest clients delay Social Security until age 70, Social Security usually covers basic expenses.
Takeaway
Variable annuities are not usually used well. People are sold variable annuities and put IRA money in them without ever setting up a guaranteed income. If you’re looking to benefit from an annuity, consider a single premium immediate annuity to help cover basic living expenses. They shift risk away from market risk and can increase your overall probability of success. If you have more money than you know what to do with, call me. I mean, you might consider a QLAC.
In my group’s research, we didn’t even look at variable annuities, because nobody believes in them. The only time they may be worth it is with after-tax, non-IRA money invested in low-cost sub-accounts and when you actually use the guaranteed income. Most people use them only to save more tax-deferred money, but the fees offset the benefit. The best way to use an annuity is to first invest after-tax money in index funds to achieve nearly efficient growth. Then buy a SPIA to cover basic expenses if they’re not already covered by your Social Security at age 70.
