Financial advisers have several good reasons for selling variable annuities to their clients. They get paid more for one thing. On most other investments, the higher the amount a client invests the lower commission rate is for the adviser. In mutual funds, this is called a “break point.” An advisor, to illustrate, may get paid 5.00% when a client buys less than $25,000 of shares in a stock mutual fund. If the purchase falls between $25,000 and $49,999, the adviser may get paid 4.50%. Thus at $24,999, the advisor’s commission is $1249.95, but at $25,000, the amount drops to $1125.00. Commission rates vary from company to company and depend largely upon the kind of fund being sold, but the break point pricing is accepted industry wide. If a client ever finds an adviser recommending a slightly lower purchase, a higher commission may be the reason.
For an industry that is capable of some of the most exotic probability computations, it is to be asked why after all these years hasn’t a formula be worked out to replace the anachronistic break point system. The variable annuity industry has solved the problem, but their solution favors the adviser and not the investor. With variable annuities, the commission schedule does not have break points in it. An adviser gets paid the same percentage at $250,000 as at $25,000. Investors need to be aware that the incentives to increase the amount of every sale are there for the adviser.
Variable annuities differ from fixed annuities in that variable annuities allow the investor access to an array of mutual funds, and the money placed in the variable annuity can be spread out or allocated among the funds available in a manner that suits the objectives and risk tolerance of the investor. An aggressive investor, for example, may want 85% or more of the money in the variable annuity directed toward equity or common stock funds. More conservative investors may prefer bond funds instead. Fixed annuities do not provide this kind of flexibility. Fixed annuities are invested as the annuity company directs. The owner of a fixed annuity usually has little or no say in the investment strategy.
Variable annuities offer the same tax advantages as an IRA or 401(k) in that the growth of the funds in the annuity and the interest and dividend income earned are tax deferred until such time as a withdrawal is made. Then withdrawals are treated as regular income and taxed as income in the year that the withdrawal is made. Unlike an IRA or 401(k), however, no tax penalty is assessed on withdrawals made prior to age 55 ½. Also, it is very important to recognize that payments into a variable annuity cannot be treated as a tax deduction. An investor is advised under most circumstance, therefore, to make a maximum contribution to an IRA or 401(k) before considering the purchase of a variable annuity.
Variable annuities are long term investment vehicles. Companies almost always impose an early withdrawal charge to offset the cost of issuing the contract and the selling costs. Early withdrawal charges are usually on a declining scale and may start as high as 15% and remain in effect for as long as 10 years after the date the contract is issued. The percentage amount charged and length of time during which the early withdrawal charge is in effect varies from one company to the next. Since most advisers represent more than one company, a client should ask about early withdrawal charges and request a comparison if more than one contract is under consideration.
In my next post, I will discuss the insurance features of variable annuities. Please watch for it. Thank you for looking in on my web site. Please feel free to check out the other pages or leave a comment below.