The Crippling Costs of Variable Annuities
by Brian Sokolowski, CFA
Bluebird Wealth Management
“Guaranteed” income for life, ability to participate in potential stock market growth, and downside protection in case of a stock market slump form a theoretically appealing combination for many people as they plan their retirement savings and investment strategies.
Unfortunately for many, the reality often falls far short of the promise which was sold to them. While this combination sounds very appealing, the sum often ends up being too good to be true. Let’s examine a few aspects of variable annuities in more detail to see if the reality is as rosy as the sales pitch.
First, some basics Although there are many different types of variable annuities, a particularly popular format is an annuity that contains some sort of minimum guaranteed withdrawal benefit (or GWB). The GWB is a rider on a variable annuity that stipulates that when the underlying investments held in the plan appreciate in value, the annual annuity payment is calculated off of this higher value. If the total value of the annuity were to decline due to a stock market selloff (or the crippling fees – which is of course not highlighted by the salesperson), the policy holder’s annual payment continues to be based upon the “high water mark” value.
While this sounds great, there are a few important clarifications. First, the high water mark is typically calculated once per year, rather than on a daily, monthly, or quarterly basis. Annual calculation lowers the actual value of the high water mark, while the perceived value remains high.
More importantly the guarantee of the GWB only applies to the level of the income withdrawal, not to the full value of the variable annuity. Remember, a variable annuity is a wrapper for a mix of underlying investments. These investments belong to the client or policy holder. The typical variable annuity has no guarantee on the principal value of the investments, but only for the annual income which will be withdrawn by the policy holder. This is a critical distinction, which will become evident when we discuss costs in the next section.
Fees for variable annuities with guaranteed withdrawal benefits are often sky high. I performed an analysis on a variable annuity purchased in 2011 for a new client of my firm. The results were eye-opening. The stated annual fee of the annuity was almost 3% (2.9%) per year. The annuity was a joint offering from two reputable large firms, and with a deeper relationship with one of the firms the client was not charged an additional fee for an adviser to “advise” on the annuity on an ongoing basis. (Advisory fees on annuities do exist in other circumstances, which elevates the fees from crippling to downright offensive).
A 2.9% annual fee is bad enough, but to the make the situation even worse, the underlying investments under-performed the blended asset class benchmarks by an additional 2% per year (i.e. – if the client were to invest in index funds according to the asset class weightings actually held in the annuity, the client would have realized returns of approximately 2% more per year, before even considering the almost 3% fee). This brings the real cost of this annuity to a whopping 5% per year. It is very difficult to discern whether the 2% drag was due to poor investment performance of the funds or higher cost structure inherent to these products, which typically have fewer investment options and flexibility.
Applying the 5% cost per year (which of course assumes the 2% performance drag of the past continues into the future, which is uncertain) indicates that to keep holding this annuity the client was paying approximately $50,000 every year (5% on his $1 million variable annuity) to insure that his future annual payment of 5% ($50,000) did not decline if the market were to fall. Please read that sentence again to let it sink in. He was not paying 5% per year to protect the full 100% value of his portfolio – he was paying 5% per year to protect that someday he would be able to receive an income payment of 5% (comprised at least mostly of his own money, or possibly fully of his own money – unless he were to significantly outlive his life expectancy).
I calculated that the client’s true cost over the six years of holding this annuity to be almost $500,000. While this was a painful conversation to have with the client, there were two pieces of good news. First, exiting these instruments are often extremely difficult due to significant exit fees and long lockup periods (put in place for the companies to be able to recoup the huge commissions paid to the salespeople). Fortunately there were no exit fees as the 5 year period had passed. There were also no tax consequences as the annuity was held in a retirement account (IRA), so the client was able to exit without a large tax penalty (holding a variable annuity within a tax deferred IRA is another issue, due to the IRA already providing tax deferred status, obviating one of the main benefits of a variable annuity).
Second, the client held the vehicle over a strong period for the stock market so while there was a huge cost, the market was strong enough to overcome this cost on an absolute basis, resulting in a net gain. If this vehicle were held in a flat or down market, the fees and performance drag would have completely wiped out any positive returns and in essence the client would be trapped as in that case the high water mark would have increasing value (but for very wrong reasons), as the GWB would look increasingly attractive in the face of declining principal value.
This client is not alone
Importantly, this is not a one-off situation, and disappointingly these fees are not outliers. I was recently informed by another new client of an attempted variable annuity sale with annual fees of 4% to the insurance company plus 2% to the “adviser” for a whopping 6% total fee, before any potential performance drag. Historic annual returns of Balanced portfolios are in the 4-8% range, depending on the asset mix and time-frame. Therefore, the expected outcome in this proposition would be a zero net return for the investor, based on a 6% gross annual gain completely wiped out by fees.
What is the alternative?
Concerns around market volatility and the possibility of outliving one’s savings are legitimate and scary. Fortunately, the financial markets allow for multiple ways to solve for the goal of potential appreciation with some level of downside protection. These goals can be attained at a fraction of the cost of the expensive variables annuities discussed above. At Bluebird, we use our deep experience in capital markets and institutional investment management to build customized solutions to help individuals meet their retirement goals.
Let us know how we can help.
Disclaimer: This publication is the opinion of Bluebird Wealth Management LLC and is for informational purposes only. It should not be considered investment advice or a recommendation of any investment strategy or security. These opinions are subject to change at any time based upon future events or market conditions.
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