Beware The Potholes
Variable annuities are complex instruments. They're not cheap and not
always the best choice for retirees. Fees typically run 1% to 1.5%
higher than average no-load mutual funds. Compounded over time, this
can add up. Are the new variable annuities worth the price?
Consider a retirement portfolio of mutual funds averaging an 11% annual
return. Over the long haul, it will experience volatility and losing
years. As sub-accounts inside a new annuity, the same investments would
generate only 9% or 9.5% average annual return because of the variable
annuities insurance cost. The retiree would, however, receive a
guaranteed income stream for life. Whether the benefit overcomes the
somewhat diminished portfolio performance is a question that must be
answered case by case.
Some variable annuities represent better buys than others. The choice
is not always obvious. Consider two variable annuities: One pays 7%
guaranteed annual income, the other 5%. Most clients will choose the
higher rate, but a key consideration, often missed by those unfamiliar
with the new variable annuities, is whether the contract treats
distributions on a pro rata or dollar for dollar basis.
Variable annuities with dollar for dollar withdrawal treatment usually offer lower guaranteed income rates because the guaranteed income base will never deteriorate, even if the actual account balance depletes due to withdrawals and an extended down market. This presumes the client does not take excess distributions.
Variable annuities with pro rata treatment typically offer higher
income rates but are subject to having their guaranteed account balance
decline in value if investment performance lags. If that happens, the
owner may be forced to choose between reducing annual withdrawals or
annuitizing the balance before it dwindles further. Both may be
unappealing options. What does a higher rate do if clients must
annuitize to get it?
Excess distributions also can be dangerous. Depending on how the
insurer treats them, they can defeat the purpose of the variable
annuity by eroding the guaranteed income base and subsequently the
guaranteed income itself. Worse, the client continues to pay a premium,
which could be as much as an additional point or more, for a guarantee
benefit that is no longer in force. In this case, the client would have
been better off funding the portfolio outside of a variable annuity.
Guarantees, of course, are based on the claims-paying ability of the
issuing insurance company, so diligence in choosing a product sponsor
is vital. Also, withdrawals prior to age 59 1/2 may be subject to a 10%
IRS penalty, surrender charges may apply and are taxed as ordinary
income. Obviously, a long-term focus must be the foundation for any
variable annuity strategy.
Responsibility To Clients
It goes without saying that the client should be instructed to
carefully review the product prospectus, but we have an obligation to
our clients to go far beyond that caution and fully explain the nuances
of the variable annuity product under consideration.
Advisors have a choice of taking an up-front commission or an ongoing
service fee from product sponsors for selling variable annuities.
Taking the commission leaves little incentive to monitor clients'
progress over the years to ensure they don't inadvertently abuse or
invalidate any of the variable annuity's provisions, such as excess
distributions.
I believe the industry would be better off if sponsors spurned up-front
commissions. It would force advisors to rely on trailing income,
prompting better service and helping clients avoid making errors or
compromising their investment objectives.
Incidentally, I don't recommend anything I don't buy for my own
portfolio. Approximately 80% of my retirement assets are invested in
variable annuities with a guaranteed minimum benefit rider.
Misplaced Focus
Advisors generally focus on optimizing investment returns to generate
adequate retirement income. For decades, we have recommended asset
allocation strategies based on maximizing investment returns. But
investing is not the goal-it's merely the vehicle. The goal is
replacing earned income with guaranteed income-or life. Somehow, that
vital point gets overlooked.
Studies show that the optimal investment mix to last a client's
lifetime is 80/20 equities to fixed income, assuming a 5% annual
withdrawal rate. But no matter how good the odds of the income lasting
long enough, there is always the chance of running out of money. There
is also the chance that poor investment performance will render the
calculations meaningless. It can be difficult to get retirees to accept
the optimal mix because the potential volatility may scare them. What
often happens is that retirees choose a less than optimal portfolio mix
with a higher chance of failure.
One advantage of variable annuities with guaranteed income benefits is
that they allow retirees to choose the most appropriate asset mix, even
if it suggests greater volatility, because their income stream is
guaranteed for life even if portfolio performance lags. This can make
life much easier for retirement planners. The principal goal of
ensuring a lifetime income stream is assured so retirees have more
flexibility and less stress in choosing investments.
Variable annuity fees, charges, investment options, death benefits and
minimum income and/or withdrawal options are among the most important
issues for discussion with retirees. Feature and benefit comparisons
among available variable annuities, as well as other investment
options, such as mutual funds, should also be considered.
It doesn't take a catastrophic crash to cause significant
injuries, in an airliner or in a retirement plan. Submitting client
retirement portfolios to emergency planning is one way to help plan for
unforeseen contingencies. Variable annuities with guaranteed income
benefits can be a valuable part of this contingency planning, provided
advisors understand their complexities, match the appropriate variable
annuity and benefit rider to client requirements and ensure that the
strategy is being employed in a long-term planning environment.
Tom Scott, based in Irvine, Calif., is a registered principal with and
offering securities through Linsco/Private Ledger. He can be reached at
[email protected] or www.tomlpl.com.