Understanding variable annuities and what all those riders mean
Posted June 20, 2021
Posted June 20, 2021
Every annuity company has its marketing names not just for the variable annuity but for all the riders (extra’s) that you can tack onto them. At its basic level, a variable annuity can be easy to understand. These stripped-down VA’s are just essentially investment vehicles that allow the owner to invest in the stock market and provides tax-deferred benefits. They don’t have any fancy bells or whistles like guaranteed income or enhanced death benefits. They usually have an M&E (mortality and expense) fee that is a percentage of the account balance (I’ve seen this M&E fee as high 1.35%, but I haven’t seen all the different options available). There is also an expense ratio/cost for the sub-account (mutual fund) that the client pays, usually around 1%. The all-in cost puts even the barest bones annuity at ~2% a year in fees paid to the insurance company. The primary benefit of this annuity is its tax-deferred status. Like an IRA, a non-qualified variable annuity is a tax-deferred vehicle which means that none of the gains are taxed until you take them out. Still, when you take money out of the annuity, the growth is taxed as ordinary income (not capital gains), and all the gains come out first.
The more typical variable annuities that I see are variable annuities with guaranteed minimum income benefits. These variable annuities are highly complex because there are a lot of moving pieces. Since these variable annuities all have different marketing names, your variable annuity may have another name for a specific feature, but they all work the same for the most part.
For a variable annuity with a guaranteed minimum income benefit, the investor must understand two different balances: the account balance and the benefit base. The account balance is the actual dollar amount the annuity is worth. This account balance is the amount of money invested in the market and is making money for you. The benefit base is a notional dollar amount that the insurance company uses to determine how much money to pay you for income benefit purposes. Usually, if you have had the annuity long enough, you’ll find the benefit base is much higher than the account balance.
The higher benefit base is because the annuity has a rider that guarantees a specific increase every year that the owner accumulates and does not withdraw funds. For instance, the Jackson National Perspective II has an option for a 5% guaranteed roll-up to the benefit base. This guaranteed roll-up means that the benefit base will increase by 5% even if the market is down or your investment performance doesn’t outperform 5%. So even though the account balance is down, the amount of money the insurance company allows you to take out goes up. The guaranteed benefit base increase is where most people misunderstand how their annuity works because they believe their account balance is going up and making money. Still, in all actuality, this is just funny money. The insurance company is only agreeing to give them back more of their own money.
The insurance companies charge an additional fee for this income benefit rider, and it’s expensive. For instance, Equitable’s Retirement Cornerstone charges 1.4% per year on the benefit base and not the account balance. So as the benefit base grows, the insurance company debits a larger percentage out of the account balance than when the client bought the annuity. This higher fee results in lower account balances, slower growth, and overall less wealth after an extended period.
Now depending on how the annuity contract is written, once the annuity runs out of money, and the account balance has $0 in the annuity, if there is a guaranteed income rider, the allowance will annuitize (sometimes you must actively elect to do this before the account balance runs out of money) and the insurance company will pay out the benefit for the remainder of the client’s life. This is finally where the policyholder starts getting into the insurance company’s money. Before this time, the policyholder is just receiving back their own money from the annuity and has already paid ten of thousands of dollars in rider fees to the insurance company.
While the guaranteed income is an attractive feature, there are many better ways of creating income during retirement that don’t cost an arm and a leg like these variable annuity guaranteed income riders. A single premium immediate annuity can offer higher income levels from a planning perspective and be a more cost-effective way to create a guaranteed income source. That being said, I’ve found that most retirees do even better without annuities and having more flexibility with accessing their retirement funds. The insurance companies put lengthy surrender periods on these annuity contracts with penalties as high as 9% of your purchase payments.
Working with a fee-only financial advisor that isn’t compensated on the sale of annuities or other investment or insurance products can help you cut through the noise and help you find the right way to invest your assets for retirement.
Thayer Financial is ready to advise you on your early retirement options from the perspective of comprehensive financial planning. As financial advisors in Hickory, North Carolina, Thayer is your dedicated resource for fee-only, fiduciary advice. Schedule an appointment or call us today.
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