Variable annuities in retirement accounts

Michael Maehl CWM, CRFA, CSA
December 16, 2008 — 2,035 views  
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Our current and prospective clients and their other advisors have sometimes wondered why we recommend using variable annuities as an investment vehicle for portions of their qualified (retirement) assets.   Many who read or listen to the popular financial media have been “taught” that it makes no sense to invest “tax-deferred money into a tax-deferred vehicle.”  Some ask why we don’t simply use the variable annuity structure with non-qualified (taxable) money to take advantage of the tax deferral.  Others question the fees associated with variable annuities.

Let’s consider some of these issues.

First, it isn’t exactly accurate to regard a variable annuity as a tax-deferred investment within an IRA.  The acronym IRA can either stand for Individual Retirement Account or Individual Retirement Annuity.  Therefore, both represent tax-deferred accounts.  Thus, while it’s true that variable annuities do provide tax deferral when used with non-qualified (taxable) assets, it’s somewhat misleading to state that we are placing qualified assets in a tax-deferred vehicle. 

Tax-deferred investments have both positive and negative attributes.  

The primary positive aspect is tax deferral.  You don’t have to pay taxes on the growth, dividends or interest earned within your account until you withdraw it.  Consequently, your account will be allowed to grow undiminished by annual taxes on capital gains, interest or dividends.  Other positive attributes include tax relief (deductions for contributions, if applicable, in the year of the contribution) and protection from creditors (in certain states).  All of these positive attributes apply equally to traditional IRAs, as well as qualified annuities.

However, qualified tax-deferred investments have their negative side as well.  

For example, withdrawals from qualified plans are taxed as ordinary income at the marginal tax bracket of the owner in the year in which the funds are withdrawn.  These marginal tax rates have fluctuated considerably over the past 50 years, getting as high as 91% in 1963.  Under the current Federal income tax structure, your marginal tax rate may be 28%, 33% or 35%.  The current long-term capital gains tax rate, however, is typically 15%.  If your qualified plan is invested for growth – as many are - then you’re choosing to defer a current 15% capital gains rate into ordinary income rates that are (and may continue to be) significantly higher.  Other negatives include the likelihood of a 10% penalty on any withdrawals prior to age 59½ and required minimum distributions (RMDs) at age 70½.  These negatives are not avoidable in the case of annuities.

Neither the positive nor the negative aspects of qualified asset investments are altered by the use of annuities.  Thus, the advantages remain when using an annuity and the disadvantages aren’t made any worse in the qualified asset arena.  As a result, we’re puzzled by the opposition of those in the popular financial media to investors using annuities for qualified assets.

Oddly, however, some of these same popular pundits and their followers do advocate using non-qualified funds as the preferred source to invest in variable annuities.  

As noted previously, we wonder why anyone would voluntarily choose to pay the considerably higher marginal tax rates on those distributions, when current capital gains tax rates are 15%.  In addition, non-qualified variable annuities, like their qualified equivalents such as 401(k)s, profit sharing and pension plans, as well as IRAs, other than ROTH, carry those same early withdrawal penalties and have RMDs beginning with age 70½. So, this argument for funding variable annuities with non-qualified funds strikes us as much more questionable than taking funds that are already subject to those rates.  These negative attributes of qualified accounts are usually strong enough to preclude us from recommending non-qualified annuities for our clients.  

Annuities have other negatives, including surrender charges.  The surrender period usually isn’t an issue for investors who don’t intend to take distributions before age 70.  It’s far more likely, in our opinion, that a client would need access to a portion of their non-qualified asset base than their qualified funds.  In certain instances, when clients lack a sufficient asset base in tax-deferred retirement vehicles, we may advocate the use of a non-qualified annuity.  With the “suddenly wealthy”, such as professional athletes or entertainers who earn enormous sums over an unpredictably short or sporadic period, we have suggested using non-qualified variable annuities in order to help secure their long-term retirement income needs.

Why do we advocate the use of variable annuities in qualified accounts?   We have a couple basic reasons.

The genesis was, simply, that the insurance companies have gotten tired of watching money fly out their doors to be invested into mutual funds.  As a result, over the past 5 to 10 years, annuity companies have begun offering living benefits to the owner of a variable annuity, typically in the form of guaranteed withdrawal or income benefits, to entice them to stay.  

The basic withdrawal guarantee is one that allows the owner to recover at least 100% of their investment, regardless of investment returns.  If you put $1,000,000 into an annuity with this guarantee, you are then guaranteed to get your $1,000,000 back - although you’ll be required to receive those funds over a period of time, most typically between 14 and 20 years.  We don’t feel that this represents an onerous constraint given the fact that these are qualified funds and therefore designed to be drawn down over an extended period of time – such as retirement.  

In addition, most variable annuities with living benefits include mechanisms for capturing any increases in market value (called ‘market step-ups’), should the investments in the sub-accounts increase in value along with the overall stock and bond markets.  Those are typically re-set on the anniversary date of when the contract was started or can be set based on other times, depending upon the issuer and specific contract.  Thus, not only does the contract owner know that the worst they can do is get their original investment back, they can also capture market upside should the markets have performed well on one of those ‘step-up’ dates.

Other annuity contract choices can include income guarantees.  These living benefits assure the owner of the right to annual income for life.  The guaranteed annual income amount usually starts at 5% of the net premium or stepped up guarantee base and can increase at pre-determined age levels.  Like the withdrawal guarantee, the income is guaranteed - even if the underlying investments continue to go down in value...all the way to as low as to zero.  We believe that income guarantees such as these are critical since retirees will almost certainly be required to take money out of their accounts during down market cycles such as we’re seeing now.  Without these guarantees, any retiree’s portfolio would be significantly reduced.   This puts serious constraints on recovering fully without taking on an unacceptable amount of portfolio risk.  It also could reduce a non-protected portfolio so that no money would be available from which to take an income. 

As we have certainly experienced over this past year, down market cycles are a fact of life.  The US stock market has generally risen over the past 200+ years, but not without significant down periods in which the market – usually - declines 10% or 20%.  While markets are historically up by some amount about 70% of the time, studies have shown that the market is down in about 1 year out of every 3.  This cycle has been in place since 1929. 

Either way, it isn’t a question of either if or when the market will go down, but more like how many times the market will go down during the average person’s retirement lifetime.  We believe that putting some of your retirement money into an annuity with living benefits insures the value of that piece of money against loss.  This can contribute greatly to your sense of security about your retirement.

We make sure our clients undestand that they are buying an insurance product when they choose to use a qualified variable annuity structure for part of their retirement assets.  That’s the source of the guarantees.  Interestingly, we don’t hesitate to insure our houses or cars against catastrophic loss.  This in spite of the fact that few of us have ever experienced an event that resulted in even a 10% or 20% reduction in the value of our homes – much less a complete loss such as an all-consuming house fire, tornado, hurricane or flood.  Given the importance of a retirement portfolio, the possibilities of reduced social security payments in the future and the near-certainty that the financial markets will experience multiple declines of 10% to 20% - or more - over the course of an entire retirement, we regard the dollars clients choose to pay in variable annuity fees and riders as perhaps the most prudent insurance dollars they'll ever pay.

Media figures who are opposed to variable annuities cite the costs of VAs as being very high and unnecessary.  Okay, during the late parts of the bull market in 1998, 1999 and 2000, it was difficult to challenge their approach of “indexes are all you’ll ever need.”  It didn’t appear difficult to pick good mutual funds or individual stocks and it sure appeared that the markets would always go up…

However, since the bear market of 2002, together with our current experience, we haven’t heard much from those previous complainers. 

The Wall Street Journal has estimated that the average internal costs of owning a traditional, open-end, growth mutual fund in the US are approximately 3% per year.  This is whether the fund is/was a load or no-load fund.  This was determined by including all internal and external costs - such as trading, turnover and tax costs – along with fund management and distribution costs. However, these costs can be lower for variable annuity sub-accounts.  Sub-accounts are the specific investment choices the investor makes within the annuity.

The very large sums being regularly invested in these sub-accounts, along with the reduced tendency of investors to switch investment choices among the many sub-account choices inside a variable annuity, allow the insurance companies to negotiate reduced fees from their investment managers.  Moreover, the insurance company is paying the costs of distributing the funds to their representatives - yet another bargaining point with fund companies. 

We look for high-quality, well rated, variable annuity providers who negotiate fee reductions and pass the savings on to our investors.  In most cases, the combined total costs (including all relevant riders) for the variable annuities that we recommend are less than 3% per annum.

To summarize, since all of the positive attributes of qualified accounts are retained in a qualified annuity, none of the negative attributes are increased and the costs of ownership are similar, the primary difference between a traditional Individual Retirement Account and an Individual Retirement Annuity are the significant guarantees available with the annuity.

With the living benefits of a high quality variable annuity, you combine no market risk to your withdrawal base, upside participation in the markets beyond your income guarantees and a guaranteed, predictable income. 

It all seems to be a fine choice for the investment of a portion of the retirement funds of a suitable investor.

 

Michael Maehl CWM, CRFA, CSA

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Following his graduation from Northern Illinois University and subsequent service as an infantry officer in the Marine Corps, Mike began his investment career in New York City in 1973. Subsequently, Mike worked as a financial advisor in Chicago and Anchorage. He was selected to be a branch manager for a member firm of the New York Stock Exchange in 1984. He relocated to Washington State in 1993, continuing to serve as a branch manager until March, 2008. At that time, Mike decided to become an independent advisor based in Spokane.