FINRA recently issued an investor alert warning “FINRA is issuing this Investor Alert to help seniors and other prospective variable annuity buyers to make informed decisions about how to invest for their retirement.”
What Are Variable Annuities?
Although variable annuities offer investment features similar in many respects to mutual funds, a typical variable annuity offers three basic features not commonly found in mutual funds:
- Tax-deferred treatment of earnings.
- A death benefit.
- Annuity payout options that can provide guaranteed income for life.
Generally, variable annuities have two phases:
- The “accumulation” phase when investor contributions—premiums—are allocated among investment portfolios—subaccounts—and earnings accumulate.
- The “distribution” phase when you withdraw money, typically as a lump sum or through various annuity payment options.
Many investors purchase a variable annuity from a stockbroker who touts a particular feature of the variable annuity. The investor makes a decision based on the verbal representations of the broker. However, the investor does not always have sufficient information to make a fully informed decision.
The documents involved in the sale of a variable annuity can be quite complicated. The prospectus and contract documents can consist of hundreds. Investors can feel overwhelmed by these documents and sometimes rely solely on verbal representations of the broker.
This can often lead to a dispute where the investor either misunderstands the broker or the broker misinforms the investor.
Evaluating Variable Annuities
The variety of features offered by variable annuity products can be confusing. For this reason, it can be difficult for investors to understand what’s being recommended for them to buy—especially when facing a hard-charging salesperson.
Before you consider purchasing a variable annuity, make sure you fully understand all of its terms. Carefully read the prospectus. Here are seven factors you should bear in mind before investing:
1. Liquidity and Early Withdrawals
Deferred variable annuities are long-term investments. Getting out early can mean taking a loss. Many variable annuities assess surrender charges for withdrawals within a specified period, which can be as long as six to eight years.
Also, any withdrawals before an investor reaches the age of 59 ½ are generally subject to a 10 percent tax penalty in addition to any gain being taxed as ordinary income.
2. Sales and Surrender Charges
Most variable annuities have a sales charge. Like class B shares of mutual funds, many variable annuity shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example, a surrender charge could start at 7 percent in the first year and decline by 1 percent per year until it reaches zero.
3. Fees and Expenses
In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses when you invest in them, such as:
Mortality and expense risk charges, which the insurance company charges for the insurance to cover:
guaranteed death benefits;
annuity payout options that can provide guaranteed income for life; or
guaranteed caps on administrative charges.
Administrative fees, for record-keeping and other administrative expenses.
Underlying fund expenses, relating to the investment subaccounts.
Charges for special features, such as:
stepped-up death benefits;
guaranteed minimum income benefits;
long-term health insurance; or
These annual fees on variable annuities can reach 2 percent or more of the annuity’s value. Remember, you will pay for each variable annuity benefit. If you don’t need or want these features, you should consider whether this is an appropriate investment for you.
While earnings in a variable annuity accrue on a tax-deferred basis—typically a big selling point—they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains, but allow your contributions to reduce your current taxable income. That’s why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans. To learn more about 401(k)s, please read Smart 401(k) Investing.
Once you start withdrawing money from your variable annuity, earnings (but not principal) will be taxed at the ordinary income rate, rather than at the lower capital gains rates applied to investments in stocks, bonds, mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year.
Furthermore, proceeds of most variable annuities do not receive a “step-up” in cost basis when the owner dies. Other types of investments, such as stocks, bonds, and mutual funds, do provide a step up in tax basis upon the owner’s death.
5. Bonus Credits
In an attempt to attract investors, many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity, generally ranging from 1 percent to 5 percent for each premium payment you make. Bonus credits, however, are usually not free. In order to fund them, insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods.
Exchanging or Replacing Your Current Annuity
An exchange of an existing annuity for a new annuity may be the only way a salesperson can generate additional business. However, the new variable annuity may have a lower contract value and a smaller death benefit. You should exchange your annuity only when it is better for you and not just better for the person trying to sell you a new annuity. To learn more about exchanges, please read our Investor Alert, Should You Exchange Your Variable Annuity?
Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company’s financial strength. Information about these agencies can be found on the SEC’s website.
7. Variable Annuities within IRAs
Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.
Also, if the annuity is within a traditional (rather than a Roth) IRA, the government requires that you start withdrawing income no later than the April 1 that follows your 70½ birthday, regardless of any surrender charges the annuity might impose.
Individual Retirement Annuities.
Some variable annuity providers sell what is termed an Individual Retirement Annuity (IRA). You should be aware that this “IRA” is not an Individual Retirement Account (IRA). The Internal Revenue Service sets specific restrictions regarding Individual Retirement Annuities, which are not met by all annuity products. To learn more, please read IRS Publication 590.
How to Protect Yourself
Brokers recommending variable annuities must explain to you important facts, including: liquidity issues, such as potential surrender charges and 10 percent tax penalties; fees, including mortality and expense charges, administrative charges, and investment advisory fees; and market risk.
Brokers also must collect important information from you about your age, marital status, occupation, financial and tax status, investment objectives, and risk tolerance to assess whether a variable annuity is suitable for you.
Before purchasing a variable annuity, you should specifically—
Ask the person recommending that you purchase a variable annuity:
How long will my money be tied up?
Are there surrender charges or other penalties if I withdraw funds from the investment earlier than I anticipated?
Will you be paid a commission or receive any type of compensation for selling the variable annuity? How much?
What are the risks that my investment could decrease in value?
What are all the fees and expenses?
If you have variable annuity losses call Place and Hanley at (866) 318-4725 or www.placeandhanley.com