Vairable Annuities — A Great Way to Protect a Retirement Portfolio

John J. Hohn and dog Jessie

Thanks for all the questions about annuities. Yes, annuities are a valuable way to protect your retirement portfolio and secure an income for your survivors. But there are several things to be considered before buying one.

There are two kinds of annuities; fixed and variable. Fixed annuities guarantee income to the owner and often the survivor at a set amount for a fixed period of time. Fixed annuities will be a topic for a later posting. Enough said for now.

Variable annuities are a hybrid product. They combine life insurance and mutual fund portfolio management into one contract. The insurance can take many different forms. The most basic benefit is that the contract insures the principle against market loss for the survivors, named as beneficiaries in the contract.

Assume an investor buys a $50,000 variable annuity either through a financial advisor or an insurance agent and directs that the funds be invested in a mutual fund portfolio that allocates 70 percent to funds that invest in common stock—equity mutual funds. Assume further that the investor holds the annuity contract for 10 years and over that period the mutual funds lose $15,000 so that the face value of the annuity is reported at $35,000 rather than the original $50,000.

But let’s have our investor open the statement, read about the losses in the face value and drop over dead from shock. With the death of the owner, the insurance features of the variable annuity come to the rescue of the named beneficiary who will collect the face value of $50,000. The owner, in other words, had $15,000 worth of insurance and did not put the principal of the contract at risk in the market.

Several conditions may apply at this point and care must be exercised to know the provisions of the contract. The death benefit may be reduced by any withdrawals taken while the owner was alive. Make sure the person offering you the contract explains all of these particulars. But lets go a step further.

More competitive variable annuities will actually guarantee a minimum level of return. The provisions vary widely from one company to the next, but in the simplest terms, a contract may state that the value of the annuity at the time of the owner’s death is equal to the highest amount the contract achieved in the market on a given date or a guaranteed amount of appreciation every year whichever is higher.

That is not as complicated as it sounds. Let’s go back to the poor devil who dropped dead over his losses. Let’s assume, further, that a contract provision guarantees that the beneficiary will be paid the face value plus 5 percent compounded annually on the initial face value or the highest level the contract achieve on any anniversary date of the purchase. The 5 percent sounds pretty good. Just remember that contracts vary widely so be sure to get this explained to your complete satisfaction before signing anything.

My wife and I invested in an annuity with her as the owner on October 25, 2002. We turned over $74,250 in payment for the initial premium. We have not made any additional payments since nor taken any withdrawals. As of September 30, 2011, the face value on the contract is $92,275, not too bad given where the market has been over the past nine years. But here’s the kicker. The death benefit on the contract is almost $110,000.

My wife has a little more than $35,000 of life insurance in the contract. She did not need to take a physical. She was not charged a rate based upon her age. She has paid a total of $2,715 in fees or about $300 a year—not just for the insurance but the management of the mutual fund portfolio and the record keeping including year-end tax statements.

Another example. On June 13, 2005, I purchased a variable annuity for $85,000. On September 30, 2011, it was valued at $97,463. It hasn’t done as well, but it is still showing a profit through a difficult period in the market.

The insurance in my annuity works differently from my wife’s contract. It guarantees an amount at the end of 10 years that the company calls a  “Guaranteed Income” base, and the guaranteed amount is $137,937. The company has assured me that, at the end of 10 years, I will have that amount in the contract, and it is the amount that will be the basis for an lifetime income stream. The annuity would pass to my wife in the event of my death, and I have the peace of mind in knowing that she would have the income of $695 a month for the rest of her life. If I live, then I would receive the income.

I was not required to take a physical. I was not charged a rate based on my age. I have paid about $650 a year for the insurance, the management of the mutual fund portfolio and the accounting and tax reporting. When you figure I was 66 years old when I bought the annuity, I think I got a good deal.

Of course, if my annuity had appreciated in value, the insurance would be a mute point, and it might be argued that the premium or fee I paid for it was money down the drain. As long as the annuity is gaining in value, the insurance is resetting every anniversary date at the value on that date. The insurance kicks in whenever the value of the annuity drops below the highest level it has ever achieved on its anniversary. I don’t mind paying a little extra for the peace of mind in knowing that my principal and the gains are not at risk in the market for my beneficiaries.

I no longer represent any annuity company nor am I compensated in anyway for the articles I write about investments. I urge all of my readers to investigate variable annuities as they consider how they want to allocate their retirement portfolios.

Please do not hesitate to ask me any questions that you may have. I will not recommend any company or agent or advisory firm. I plan several posting on this subject in response to the questions that were sent in regarding my earlier articles.

Now that I am retired, my primary energies each day are directed to my family, my writing, my golf and my dog. I invite you to take a look at my novel, Deadly Portfolio: A Killing in Hedge Funds ,that is based on my years as a financial advisor. So many have said it is a great read. It would make a great gift! I thank you.