Variable Annuities — Great, But Be Careful

John J. Hohn and dog Jessie

If you have researched variable annuities on your own, you know that I couldn’t cover everything in one blog on the subject. Variable annuities have their drawbacks. It is important to be aware of them.

A variable annuity is a long-term investment, one that you will want to hold your entire lifetime. It’s the place that you stash away the last dollars you ever expect to spend. While contracts vary, most charge a penalty fee for early withdrawals. The early withdrawal fees are on a declining balance—beginning with steeper fees in the first year or two and then drawing down until they are closed out, usually in seven to ten years. In some cases, the contract will set a limit on how much can be withdrawn in the first few years without being subject to a withdrawal fee. The limit is usually 10% of the total in the contract. The provision allows withdrawals without penalty in smaller amounts in case of an emergency. Make sure the person presenting the annuity explains these provisions.

Variable annuities are more expensive the mutual funds. The annual fee includes a premium for insurance coverage. The person selling you the annuity gets paid more in commissions on an annuity sale than on a mutual fund sale. Do not put more than about 25% of your total investment dollars in an annuity. Be watchful. Some may want to sell you more because the seller makes more money and willingly ignores the guidelines.

The amount the agent or advisor gets paid is not subject to what the industry calls break-points. He or she gets paid as much commission on the last dollar as on the first. This is not true with mutual funds. Mutual funds pay a smaller percentage in commission as the amounts invested increase. Thus, the incentive for the agent or advisor is to get you to invest as much as possible. Be suspicious if you get pushed to invest more than the guidelines dictate.

The subject of break-points comes up in my novel, Deadly Portfolio: A Killing in Hedge Funds, as Morrie Clay attempts to justify a purchase for a client with his senior partner, Matthew Wirth. The scene makes the point and opens with Wirth asking Clay a question.

“But three-quarters of a million dollars,” Matthew countered. “Why $749,000? My God, if you’re a going to bet the ranch, why not a cool $750,000?”

“There was a break-point on the commissions scale at $750,000. It dropped to one-and-three-quarter percent. Anything between $500,000 and $749,999 paid two-and-an-eighth. $749,000 paid almost $16,000 in commissions. $750,000 paid just a little over $13,000. $16,600 put us into the next compensation level and earned a bonus. $15,000 would have left us short.”

“God damn it, I’ve been in this business for almost twenty years, and I never thought like that.”

Yes, Virginia, agents and advisors sometimes get paid more for selling a client less. The industry can change this but they have refused to do so decades.

A variable annuity limits you to only those funds that the annuity company makes available. Sometimes that will be only the funds managed by the annuity company itself, which is not desirable. You are far better off with an annuity that includes funds offered by a variety of mutual fund companies because you will usually get better performance. The annuity company may in fact search for the best performers available. Diversification is the first rule of risk management. Do not forsake it just because you are buying a variable annuity.

You need to consider two choices in how your variable annuity will be managed. You can either direct the investments yourself or turn the month-in-month-out management over to the annuity company. Don’t elect to direct the investments yourself unless you are willing to be diligent in your research and have confidence in your own experience as an investor. I was a financial advisor for 16 years and managed funds for a major trust company in the Southeast. I DO NOT direct my own investments–if that serves as a guide.

If you elect to have the annuity company manage the portfolio, you need to choose from a series of allocation models ranging from conservative to aggressive. Usually at least 5 models are offered. You may be asked to answer a questionnaire to help determine your level of risk tolerance. Take the test and be honest with yourself. See my earlier posting on this subject. The allocation models will vary the percentages allocated to various funds available.

If you are going to be aggressive anywhere in your investing, a variable annuity is the place. Your principal is insured against market loss. The downside to being aggressive is that you may find more volatile performance unsettling. Other than that, if ever you needed the funds in an emergency, it would be very unfortunate to find that your annuity held less than you needed. But look back to my earlier point. You should not have more than 25% of your retirement portfolio invested in variable annuities.

Make sure that you are dealing with a quality company. Don’t take the representative’s word. Check out A. M. Best’s, Moody’s and the S & P rating. You want a company with the high quality rating that states that can meet their insurance obligations and one that has been in business for a very long period of time, at least 50 years. The mutual funds in the contract are insured by Securities Investor Protection Corporation, SIPC, which is the investment industry counterpart to FDIC where you bank. SIPC does not insure the promises made by the annuity company, however. It insures only the value of the mutual funds at the time the company went out of business. The guarantees and promises the annuity company made will go down the drain with them. Further, as a retiree, you will not want to wait months for the SIPC to honor the claims of investors hurt in the collapse of the annuity company.

If you have $100,000 or more to invest in variable annuities, split your investment up among two or more quality companies. This is just simple diversification. Your advisor or agent may have incentives to place as much with one company as possible, so be alert to the pressure. Annuity companies sponsor contests and extend awards to top producers.

On balance, the advantages to a variable annuity far outweigh the disadvantages. I plan one more posting on this subject. Watch for it in a few days.

Honor our veterans!

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.

I invite you to take a look at my novel, Deadly Portfolio: A Killing in Hedge Funds, that is based on my 16 years as a financial advisor. So many have said it is a great read. It would make a great gift! Thank you.