Variable Annuities: The Truth Behind the Selling Points (January 2009)

Joe Paoloni

The key selling points to the Some Variable Annuity (VA) is that you are guaranteed no less than 6-8% return per year, you can will your balance to your survivors after death; and, you have access to your money by withdrawing your entire balance at any time before death.  These are the compelling reasons to sign up for a variable life annuity. Yet in practice, this is at best misleading, and in some cases simply not true.  Let’s take each alleged benefit independently.

You are guaranteed no less than 6-8% return per year. 
You are not guaranteed 6-8% per year.  The VA keeps two running accounts, one which is actual balance of you investment less the excessive fees, less withdrawals, and plus or minus gains or losses much like any traditional asset account.  The other is a phantom account, a running total of a benchmark account which is solely used to calculate the withdrawal amount by incrementing the larger of the alleged guaranteed return (6-8%) or the actual return.  The end result is that the 6-8% increase to the phantom account only lets you draw more principle from your account.  This account is simply used to calculate the withdrawal amount of which is deducted from your actual investment account.  You do not and never will receive any of these funds!  Thus, you are not guaranteed 6-8% per year.

You can leave something to the next generation.
This selling point is an attempt to argue against having chosen the annuity where when you die and have nothing to will to survivors.  This is no different than a lump-sum where if you lose and use it all you leave nothing to the next generation.  Yet, if there ever was anything left to leave after your withdrawals then it would be after a series of good returns, where the lump-sum would have been the better choice.  If you had had a series of poor returns then you would have lost all your principal in both the lump sum and the VA and you would have nothing to leave to survivors anyway.   You would have nothing left to leave as your account’s principal has been all paid to you.  If you had poor returns, the traditional annuity would have been the better option.  The VA is never the best choice.  This may appear to be an advantage over the traditional annuity, but the low monthly withdrawal rate of the variable life annuity to the higher and sooner withdrawals realized by the traditional annuity is pale by comparison, rendering any future dollar excesses for future generation less beneficial

You have access to your money by withdrawing your entire balance at any time
This is easily accomplished with a traditional investment account where your funds are invested and you draw down funds as needed, but without the high management fees of 187-400 basis points.  These high fees are for the sole benefit of providing insurance to continue paying you an annuity once your account has been depleted.  By withdrawing early, you’ve paid high fees for a benefit you will never hope to receive.

So where are the benefits?
The variable life annuity takes at best a second place to either the lump-sum or the traditional annuity for every possible return scenario for all estimates of longevity and benefit commencement.  When returns are in the most probable range based on statistics with a 98.0% confidence interval, the variable life annuity comes in last and behind both the lump-sum and the traditional annuity.  When returns are low or negative the traditional annuity is better.  When returns are higher the lump sum is better.  The Achilles heel of the Variable annuity is longevity coupled with continuous below normal returns.  This is what you’ve paid the high fees for, when the variable annuity pays out long after your account balances have been depleted, but still a distant second place to the traditional annuity.  In such an environment, the question then becomes whether the VA can weather the storm and attract new capital to make continued payouts as the structure becomes more “Ponzi” like.  The best advice is to find a fee based investment advisor with Limited Power of Attorney to investment accounts in your name.

 

The following is the Net Present Value profile of the three investment schemes over a range of average returns for a 30 year period for a 50 year old investor who dies at 80: