Variable Annuities Insure Beneficiaries Against Loss Due to Market Risk
This is the second in a series of articles that I am writing on variable annuities. Readers are urged to read the first installment before tackling the one that follows.
My initial article about variable annuities stressed:
- Financial advisers have strong incentives to sell variable annuities as they pay more in commissions than most other investment vehicles.
- Variable annuities offer an array of funds into which the owner can allocate funds based upon the owner’s objectives and risk tolerance.
- Variable annuities offer tax-deferment of capital gains and dividend and interest income, none of which need to be reported until funds are withdrawn from the annuity.
- Contributions to variable annuities are not tax-deductible as with IRA’s, 401(k)’s or 403(b).
- Annuity companies charge an early withdrawal fee during the first several years that an annuity is in place. Funds can be withdrawn, however, prior to the age of 59 ½ without incurring a tax penalty from the IRS.
Everyone knows that investing entails risk. The stock market goes up and down. The bond market is in and out of favor. Even gold and precious metals can be volatile. Nothing is an absolute sure thing.
Variable annuities, however, assume most of the market risk for the investor by insuring the amount invested for the beneficiaries named in the contract in the event of the owner’s death. Thus, the value of the owner’s estate is not subject to market risk. This is an attractive option for investors who are within a decade or so of retirement when mortality becomes a very serious component in financial planning for a surviving spouse or children.
To illustrate, an investor could fund a variable annuity with $50,000. The contract would insure the initial investment so that, if the value of the investment dropped because of poor market performance to, say, $30,000, the named beneficiary would be paid the initial amount of $50,000 in the event of the owner’s death.
Protecting the Growth
Further, many companies insure the value of a variable annuity beyond the amount of the initial investment. Many contracts stipulate that the company will pay the highest amount achieved on the anniversary of the effective date by the funds in the contract. The original $50,000, in other words, might grow so that on the third anniversary of the contract, the variable annuity is worth $70,000. If, in the year thereafter, the market collapses, and the stated value of the funds within the annuity drops to $45,000, the beneficiaries named in the contract would receive the $70,000 value level recorded on an anniversary date.
Contracts do not insure the highest level achieved in the market. They insure the highest amount achieved and recorded on an anniversary of the effective date of the variable annuity.
Over the years, additional insurance features have been added to variable annuities and companies are continuing to innovate. Insured income is one such innovation and one that I plan to cover in my next article.
Not a Substitute for Life Insurance
Insurance against market risk is a major advantage of a variable annuity. It is not a substitute for life insurance, but a supplementary protection for the estate of the owner. Fees for variable annuities are higher because of the life insurance feature. The health and age of the owner is not considered in the application. The insurance component of the fee, therefore, is a flat charge, and it is the same for all owners as the contract is not rated as a life insurance policy would be.
Because variable annuities are long term contracts with early withdrawal fees, they should be considered only when other contingencies have been addressed in a financial plan including an emergency contingency fund, fully funded retirement plans such as an IRA or 401(k). Usually owners are advised not to tap into a variable annuity for retirement income but to hold them in reserve because of their insurance value. The reserve strategy presupposes that other funds will be invested to supplement retirement income from social security and/or pensions. Under most circumstance, a balanced financial plan for retirement would commit no more than 25 per cent of a portfolio to a variable annuity. Although variable annuities are covered by the Security Investors Protection Corporation (SIPC), it is generally not advisable to invest more than 10 percent or $500,000 in any one variable annuity company.
Considering Only Financial Strong Companies
Prospective buyers should consult Best’s Insurance Guide for the rating of the strength of the company(ies) being considered. Do Not Accept the adviser’s or salesperson’s word. Best’s rating system is very sophisticated and uses language that is calculated not to offend the companies being rated. That said, the description that Best’s give whereas further study often reveals that they are not a good choice. Final selection of a company should be from top two or three tiers of the Best system. The hierarchy of the rating system is explained on the internet and in Best’s published annual volumes, the latter being available at most public libraries.
Variable annuities are a very valuable retirement and estate planning investment. The designation of primary and secondary beneficiaries facilitates immediate payout of the proceeds of the contract upon the death of the owner, unlike the rest of an estate which can be delayed by probate or actions on behalf of heirs in protest against a will or revocable trust. Care needs to be taken in selecting a contract and the company making it available. The purchase is not a casual decision. Any buyer being rushed to a decision should be suspicious of the salesperson’s intentions or the quality of the product being recommended.
Thanks for checking in. I welcome comments below and invite you to look through the pages of my web site. Watch for my next article on variable annuities which ill be posted in a few days.