Variable annuities-good or evil?

    Although my partner Deena Katz and I share this column, this one rests solely on my shoulders. It is also a rather difficult article; I'm not used to publicly debating with myself. However, reflecting on my recent participation as an expert witness in a number of cases centered on the issue of variable annuities (VAs), I recognized that my thinking on the subject has significantly evolved over the last decade. With the hope that there might be value for other practitioners, I decided to devote this article to sharing my own internal debate on the issue.
    It's no secret to advisors that VAs are an immensely popular product and a plethora of media copy is devoted to their use and misuse. Unfortunately, in my experience, the discussion is rarely balanced. In order to focus on the core issues in the debate of "good vs. evil," I've elected to focus my discussion on the nontax shelter benefits (i.e., the only benefits available to an investor in an IRA). This results in a more detailed consideration of the product's most often debated nontax benefits.

    I believe that my first public pronouncement on the subject of VAs was a January 1997 quote in Humberto Cruz's nationally syndicated column: "Under any rational scenario, the real value of the guaranteed death benefit is negligible." Never one to hide my feelings, referencing the tax shelter benefits of VAs, I told Business Week in July '97 that "I've run scenarios upside and down and backwards, but it just doesn't work out. You end up turning gold to lead," a reference to converting potential capital gains to ordinary income. Finally in September of 2000, I told Bloomberg Wealth Manager, "The only reason to consider buying an annuity is if the agent is your son or daughter." Pretty strong stuff. In hindsight, I believe my heart was in the right place but my framing was far too narrow.
    Since then, my thinking on the subject has evolved as I studied and learned more (as, I hope, my thinking on all of the planning issues important to my clients continues to evolve). By November 2002, I told Money Magazine "A year ago, I would have washed my mouth out with soap if I said the word 'annuity.' Now I believe they can be an important part of retirement planning." What were the elements leading to my new perspective?

    One of the central concepts of my favorite subject, behavioral finance, is "framing." i.e., how our response is influenced by how an issue is presented. Consider-would you rather purchase a snack that's 90% fat free or 10% fat? I believe that much of the acrimony in the VA debate is a result poor framing.
Investment vs. Risk Management-If a VA policy is considered simply as an investment product, the noninvestment features are instantly relegated to a minor, minimal-value role. If however, the recommendation of a VA is considered only one of two important recommendations-namely as a risk-management tool-the noninvestment features (particularly the mortality and life income guarantees) may be raised to a significant level. Further, in my experience, most of the losses claimed relative to the misuse of VAs have nothing to do with the VA product. Based on my experience as an expert witness on both sides of the issue, the losses are generally attributable to the second recommendation, i.e., the nature of the underlying subaccounts.
    Free vs. Fee: If the costs associated with a VA product are evaluated in an environment of no-cost investing, they may appear outlandish. Unfortunately (or perhaps fortunately for practitioners), we live in a world of profit, fees and commissions. Not unreasonably, product manufacturers and professionals like to get paid.
    Cost vs. Value: When evaluating the out-of-pocket costs for some of the benefits, all too often the framing confuses "need" and "benefit," and "cost" and "value." There is often no consideration of the value of the associated benefits. This framing is natural, as it's relatively easy to quantify need and cost but difficult to quantify benefit and value. The result, however, may be to ignore the significant value a client may place on a particular benefit. Most of us drive cars far more costly than justified by the pure need for transportation. Some probably drive very expensive cars that even by a generous stretch couldn't be justified unless we place value on the benefits of prestige and bragging rights.
    Consider the components of costs in a VA product:
    Administrative costs
    Risk-This incorporates three elements of risk assumed by an insurance company:
        1. Expense guarantee 
        2. Mortality
        3. Annuitization rate
    Development Cost and Issuer Profit
    Acquisition Costs-Commissions
    Subaccount expenses
    The administrative costs are associated with the operational maintenance of the product (e.g., client correspondence and reports, trading/rebalancing, payouts, subaccount accounting). The costs associated with these factors are generally separately denominated and rarely subject to criticism. The debate is focused on the catchall "M&E."
    The M&E (or Mortality and Expense) cost has a jaded history that I believe is related to poor framing by the insurance industry in the early days of the product. Namely, the implication, often as described in the prospectus, that the M&E cost was primarily due to the actual cost of the mortality guarantee. As Professor Milevsky(1) has so thoroughly demonstrated, the cost solely associated with the mortality guarantee is typically less than 15 bp. It was my falling for this inappropriate framing that led to my quote in the Cruz article.

    Consider a VA in an IRA account as a risk management recommendation by an advisor, who expects to be compensated for his or her advice, and who believes that the client's investment exposure should be 100% to large-cap equities.(2) The chart above, based on the use of VAs in the load universe, uses estimates of average costs for alternative investments.(3)
    Although 39 bp is far less oppressive than 125 bp, this cost may still outweigh the economic costs of the VA benefits. As noted earlier, the mortality cost associated with the death benefit is likely to be less than 15 bp, the cost of the expense guarantee is unknown but likely to be minor and, at least contemporaneously, the cost of the annuity guarantee is negligible as the guaranteed rate is generally well below the current market rate. Thus, there remains the question of the "value" of the benefits.
    As behavioral economics has demonstrated, our clients are not rational; they are human. As a consequence, benefits and hence, real "value," can only be determined by an informed consumer.
    For example, in my practice I advise many wealthy clients. Some of those clients elect to purchase long-term care insurance. Do they "need" the coverage? Not from a risk management perspective. Should one of the spouses find themselves in need of long-term care, their high six-digit family expenses are likely to drop precipitously (no more expensive cruises, fancy dinners, outlandish wines, long ski vacations and club golf dues). However, after discussion and a clear understanding on the part of my clients that they would be purchasing coverage that they don't "need," I often recommend its purchase. Why? Because they can well afford the premiums and they simply sleep better knowing it's in place.
    How does this all translate into "suitable" recommendations on the part of an advisor?

    Probably the best single guide regarding the elements of suitability is NASD Notice to Members 99-35, "The NASD Reminds Members of Their Responsibilities Regarding the Sale of Variable Annuities," issued by the NASD in May 1999. Presented as a guide (not mandatory procedures) for NASD member firms, it is equally instructive for all advisors. The main points of the notice are:
    Gather appropriate customer information - for example:
    Age: clearly a critical factor. At younger ages, in nonsheltered accounts the tax deferral benefits have longer to accumulate value and the value of the annuity guarantee may be greater; however, the mortality benefit may be less. Given the importance of a long-term investment horizon and the potential negative tax consequences of VA investing (loss of step up in basis), age becomes a particular factor as an investor reaches 65 and older.
    Marital status: important for tax and risk management considerations.
     Tax status: a rather obvious consideration for taxable accounts. The redundancy of the tax shelter benefit of a VA is an important issue to discuss when recommending the use of VAs in sheltered accounts.
     Occupation & Past Investment Experience: This may provide background regarding a client's ability to understand the nature of the product and his or her potential liquidity needs.
     Other investments, savings, liquid net worth and annual income, and potentially important considerations regarding liquidity needs.

Discuss Relevant Facts With Clients
    Although this is part and parcel of the practice of most (although not necessarily all) registered investment advisors, a claim of nondisclosure is often the basis for a claim against an advisor. Unfortunately, years after the fact, it is often difficult for a third party (e.g., an arbitration panel) to distinguish between a legitimate claim and someone looking for a market guarantee (in hindsight) using the Sergeant Schultz (5) defense-"I know nothing." For a competent professional, the best protection is a well-thought-out recommendation supported by well-maintained records.

    As I've studied the issue more, as the product has evolved, with the experience of the bear market of 2000-2002, and as I've begun to focus more and more on the issue of distribution, my Evensky vs. Evensky VA debate has obviously resulted in the modification of my opinions regarding the potential efficacy of VAs.
    However, lest I've gone overboard in the presentation of my reframing, let me emphasize-VAs are not for everyone and they're certainly not for everyone's IRA. It is also true that the commission structure of VAs vis-à-vis other alternative investments may improperly cloud an advisor's recommendation.(6)  I continue to see misleading ads and articles regarding the use of VAs and I've seen their inappropriate recommendation in numerous arbitration cases that have crossed my desk.
    My point is that VAs don't have morals. They are neither good nor evil; however, they may be suitable or unsuitable. Rather than condemning their use outright, the question of suitability is very fact and customer specific. The responsibility of a professional advisor, whether subject to NASD, SEC or State regulation, is to provide, in light of the client's unique needs, goals and personal circumstances,  well-founded and credible advice regarding the suitability of a VA and the suitability of the recommended subaccounts.

Deena Katz, CFP, and Harold Evensky, CFP, are nationally recognized financial advisors. Katz is president and Evensky is chairman of Evensky & Katz Wealth Management in Coral Gables, Fla.