Variable Annuities: Popular but Perilous (June 2008)

Written by Dominick Paoloni

Variable Annuities are among the most popular investments sold today, but investors should be skeptical and cautious when considering their purchase. Hidden fees, extreme volatility, and misleading advertising can place investors in harm’s way.

I recently bumped into a local stock broker who told me that his business has never been better. He said with the recent down-turn in the markets he is moving his clients from stocks and mutual funds to Variable annuities. According to LIMRA, international sales of variable annuities rose 13% in the second quarter of 2007, even before the market started to collapse in October. 1

Sales of variable annuities have exploded in recent years because they are being touted by brokers (and the accompanying marketing material) to be the perfect investment. Although variable annuities are advertised and promoted as a safe investment alternative that can provide growth, safety & liquidity to investors (the “3 magic words” in financial planning), upon further inspection we find that most of these products do not offer even one out of the three benefits. Helping clients understand the hidden pitfalls and inefficiencies of this investment strategy is both prudent and necessary. As Richard Nixon once said, “the devil’s in the details.” With variable annuities, truer words were never spoken.

I find the marketing material on variable annuities to be misleading and filled with half truths. The following is a brief overview of the pitfalls:

• The guaranteed minimum accumulation interest comes with a yearly cost and the value of the account at the end of the accumulation period is not yours to withdrawal unless you annuitize.

• When you annuitize an annuity, the internal rate of return is well below market rates.

• The available mutual funds inside an annuity tend to be poor choices and regularly under-perform their respective index classes.

• Mortality and expense charges piled on top of the mutual fund costs cancel out any tax deferred benefit.

• The GMIB (Guaranteed Minimum Income Benefit) is not interest but is pulled out of principal—you are pulling out your own money. The cost of this rider is used to insure the gap between calculated life expectancy and actual lifetime is covered if you outlive your expectancy.

• If you pull money out of the contract while in the GMIB pay down period you destroy the current GMIB payout.

• If the mutual funds in your annuity are down when you take money out you can collapse the GMIB rider.

Digging into the Details

The GLWB (Guaranteed for Life Withdrawal Benefit)—common in most current variable annuity policies—is touted by salespeople as a solution to obtain a retirement income for life.

The GLWB rider guarantees the policyholder an amount of money for life while still being invested in mutual fund sub-accounts (an important item to note is that withdrawals are not coming out of interest; the money draws from principal).

This GLWB feature still allows the policyholders to access their account value if needed and does not force the policyholder to give up access through annuitization. However, I find this caveat a bit disingenuous—if the sub-account value drops because of poor market conditions and the policyholder needs to withdraw from the account for emergencies above the 5% to 7% allowed through the GLWB contract feature, then he or she will destroy the income stream. In effect the client becomes trapped into not touching principal, which is of course preferred by the insurance company.

Examining the Costs

Most annuities with the GLWB offer an income stream that start out with a 5% payout to age 65 and increase this amount if the payout begins at an older age. The GLWB rider has an average cost of approximately 0.25% to 0.65% a year. 2

The insurance company states the GLWB can give investors 5% to 7% per year of their money back and guarantees that it will never run out, even if the investments inside the variable annuity perform poorly. Yet, like all insurance, this protection comes with a cost. The question we need to ask is whether the fees, costs and commissions embedded in the product are value-added.

According to the National Association of Variable Annuities' (NAVA) 2005 Annuity Fact Book, fees vary in variable annuity sub-accounts. Average fees range from 0.623% for money market funds to 2.3% for bear market domestic stock funds, putting the mean cost of mutual fund sub-accounts inside Variable annuities at 1.415%.

According to Morningstar data through the second quarter of 2005, added to the mutual fund fees in a variable annuity contract is an additional 1.211% in fees for mortality and expense costs. These are standard fees, including insurance charges and basic death benefit guarantees.

If we add all of the fees, the total cost of the contract to the investor is 2.626% (1.415+1.211). When we add the mean cost of 0.45% for the GLWB rider, investors are paying 3.07% a year in fees, which eats into their return. 3 Again, does this cost justify the investment’s value, and are the benefits received from a variable annuity worth the cost?

Do the Expenses Add Value?

To determine whether the expenses add value, we must first examine the sub-accounts available inside variable annuity portfolios. Out of 1291 Variable Policies in the Morningstar database, consisting of 61,324 sub accounts, there are 19 distinct mangers (funds) that meet my basic investment criteria, justifying their cost against the value they deliver. 4

At first glance, having access to 19 value-added mangers doesn’t sound too bad. To build a well-diversified portfolio at our firm, we use between 7 and 16 value-added managers across our three portfolios; so on the surface it would seem that variable annuities could work within institutional-level money management practices.

When delving deeper into the data, however, we discover that variable annuities only allow the investor to work within the sub-accounts contained in their particular policy. And although there are 19 value-added managers available in contracts throughout all variable annuities on the market, I couldn’t find any single policy with more than three value-added managers, and most policies contained 1 manager or less. You need more than one strong manager in an account to create proper diversification and leveraged performance. Without great fund managers, you simply can’t build a valued-added asset allocation model inside a variable annuity that justifies the cost.
Even in a best-case scenario, where you have access to one good small cap manager, one strong real estate manager, and one stellar emerging markets manager for use in your variable annuity accounts, you still could not create a sound balanced portfolio, regardless of how strong the managers are. There are simply too few asset classes represented to build a properly diversified portfolio.

Why is this significant? Because in variable annuities you are paying active management costs for a portfolio that can’t even keep up with the indexes in which they are invested. As Scott Burns points out in his July 2006 article in Uexpress, “…the homely index fund, after all taxes are paid, would have ranked 10th against 178 managed (variable annuity sub- account) contenders.”5

In conclusion, many investors pay for a GLWB rider to guarantee an income flow that wouldn’t be necessary if they turned to better risk/return asset models in self-directed investment accounts.

What is the Benefit?

Given this evidence, why do investors purchase variable annuities with such fervor? Recently a brokerage firm manager spoke to this issue in a discussion regarding the mounting variable annuity sales in her office. She explained that a mutual fund wholesaler visited her staff to discuss other products, like a well-diversified asset allocation model of mutual funds. Yet her brokers didn’t want to learn the complexities of asset allocation modeling—they found variable annuities to be much easier to sell and to oversee.

I politely told her she was being naïve—I believe the reason her brokers were recommending variable annuities was because of the huge commissions they generate. She disagreed.

In addition to the perceived benefit that the GLWB income stream supposedly offers investors, what other benefits do salespeople offer to convince consumers to make a purchase? Variable annuity advocates will argue that compounding tax deferrals help justify the cost of this investment type. The problem is that variable annuities do not receive the advantages of long-term capital gains and qualified dividend rates, and therefore any tax deferrals are negated.  What’s more, assets that are already tax-deferred certainly wouldn’t benefit inside a variable annuity, though I often see poor planning in this regard with brokers placing IRA assets inside variable contracts.

Research demonstrates that variable annuities do not “live up to the hype” and that their increased costs do not justify their value to investors. According to Milberg, LLP a law firm that prosecutes advisors for inappropriate investment advice, “State regulators identify Variable annuities as one of the top 10 scams in America.” 6

As Scott Burns points out in his article, “It’s The Expense That Makes Variable Annuities Bad,” “My beef with variable annuities isn't personal. It's the math. The primary flaw of variable annuities is that the cost of the product exceeds the value of its tax deferral.”6

Variable annuities sold through different carriers vary, but most are variations on this basic theme.   When looking at an annuity you have to ask, “How is the insurance company giving my client guaranteed interest above market rates and still making a profit? Additionally, how are they paying their sales force and the mutual fund company?” The answer is: they are not. If it sounds too good to be true, it is. You think you are buying a Lexus, but once you drive it off the lot you will realize you own a Hyundai. Caveat Emptor—buyer beware.

Footnotes:

1. Drescher, Howard. "Record U.S. Individual Annuity Sales and Assets in Second Quarter 2007." insurancenewsnet.com 11 Sep 2007 8 Jul 2008 <http://www.insurancenewsnet.com/article.asp?a=top_news&id=85175>.

2. Hoffman, Ellen, Don’t Believe the Hype (Business Week: February 7, 2005).

3. Hoffman, Ellen, Don’t Believe the Hype (Business Week: February 7, 2005) This mean is calculated based on information from the Business Week article, “Don’t Believe the Hype.”

4. I screen all mutual funds using at least four key criteria: management tenure greater than at least 3 years, best-fit alpha greater than 3.07%, (the average cost of carrying a variable annuity), best-fit correlation coefficient (R2) greater than 90 (documenting the manager is truly showing added value in his/her specified asset class) and an informational ratio that is positive (this data point documents how consistently the manager is able to deliver positive alpha).

5. Burns, Scott, Index Fund Wins Race Against Variable Annuity Stable (uExpress: July 9, 2006).

6. Burns, Scott It’s The Expenses That Make Variable Annuities Bad (uExpress: July 31, 2003).

7. "Variable Annuities." Milberg LLP. Milberg LLP. 8 Jul 2008 http://www.milberg.com/page.aspx?pageid=5299>.

8. Lankford, Kimberly, The Great Annuity Rip-Off (Kiplinger’s Personal Finance, January 1, 2007).

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.