Variable Annuities and Equity-Indexed Annuities

Variable annuities are a type of alternative investment. In essence, they are insurance contracts issued by insurance companies and sold by a variety of brokers with insurance licenses. The investor’s money is invested in mutual fund-like accounts called sub-accounts. Variable annuities have been aptly likened to mutual funds in an insurance wrapper.

There are two kinds of variable annuities: immediate and deferred.

A deferred variable annuity is a two-phase product. Phase one is the accumulation or “deferral” phase. During the deferral phase, the deposited money may increase or decrease in value, depending on the performance of the underlying investments, and the effect of various charges. Any gains accrue on a tax-deferred basis, like a traditional IRA.

Phase two is the distribution or annuitization phase. At the end of the deferral period, the investor can usually withdraw the entire account value and walk away without a penalty, or annuitize it – i.e., convert it into an immediate annuity.

The principal selling point for deferred variable annuities is tax deferral. If you have maxed out on your traditional IRA and 401(k), but desire additional tax-deferred savings, a variable annuity could make sense. In addition, variable annuities have a life insurance component that varies from product to product, but generally guarantees against a loss of principal if the investor dies during the deferral period and the investments have lost value. As noted, the product can be converted into a lifetime annuity.

When compared to low cost index mutual funds, however, variable annuities often suffer from a number of problems and risks that outweigh the benefits.

With regard to tax deferral, variable annuity distributions (whether annuitized or not) are taxed as ordinary income rather than the lower capital gains rate. The tax reform act of 2003 significantly lowered the tax rate on capital gains and dividends, thereby further diminishing the tax-deferral benefit. Variable annuities are sometimes sold to investors to place in an IRA account. In such cases, the tax-deferral benefit is superfluous. Therefore, a variable annuity is only appropriate in a retirement account if there is some benefit other than tax deferral.

The insurance wrapper is inordinately expensive. Variable annuities pay high commissions to the seller – often 6% or more. While the commission is often paid by the insurance company and not deducted from the investor’s invested amount, the investor pays for it indirectly by either subjecting the invested amount to high operating (investment sub-account) expenses for 7 to 15 years, or paying a surrender charge for withdrawals that exceed a nominal specified annual withdrawal benefit. The surrender charge, which typically declines each year, can start as high as 10% in year one and decline over a period of up to 15 years.

Thus, if the investor wishes to avoid the surrender charge, the invested amount is locked up for a long period of time. Should an emergency need for liquidity arise, the investor must either find liquidity elsewhere or pay the surrender charge to cash out.

With regard to the life insurance benefit, the cost exceeds the benefit. One study showed that a simple return-of-premium death benefit was worth between 0.01 percent to 0.1 percent, but the median charge for this benefit was 1.15 percent. In addition to its high cost, the death benefit is rarely used. The percentage of variable annuities surrendered as a result of death or disability is less than 0.5 percent, and only a small fraction of those trigger the death benefit.

Because of the commission-based distribution system, variable annuity sellers have a strong financial incentive to recommend the product despite its flaws and unsuitability for most investors. That is why it is often said that variable annuities are sold, not bought.

Sellers sometimes engage in a form of variable annuity churning called “switching” to generate new commissions, even from dissatisfied customers. A variable annuity customer who is unhappy with the investment performance may be pitched to surrender his old variable annuity and buy a new “better” one. The surrender charge will supposedly be offset by an up-front bonus paid by the new variable annuity. Unfortunately for the buyer, under many annuities the up-front bonus is lost unless the new variable annuity is annuitized (which, sellers know, rarely occurs) and a new even longer surrender period at an even higher rate is commenced.

Some new annuities have features, such as guaranteed income riders, that can make them more attractive. Even in these cases, however, the buyer should carefully weigh the added cost of such a rider to make sure it makes sense.

Variable immediate annuities are even more complex than variable deferred annuities. People generally buy immediate annuities to reduce the risk of outliving their assets. Most of the same general principles set out above, however, also apply to variable immediate annuities. In addition, variable immediate annuities present interest rate risk. That is because the annuity payments rise or fall to the extent the performance of investment sub-accounts exceed or fall short of an “assumed interest rate.”

The payment obligations of an insurance company are only as good as its ability to pay. Therefore, an annuity buyer should only consider annuities issued by the highest rated insurance companies.

The Financial Industry Regulatory Authority (FINRA), which is charged with policing the sales practices of investment brokerage firms, has issued investor alerts regarding the aggressive marketing of variable annuities. In its May 27, 2003 Investor Alert, the NASD (now FINRA) said: “The marketing efforts used by some variable annuity sellers deserves scrutiny – especially when seniors are the targeted investors. Sales pitches for these products might attempt to scare or confuse investors. One scare tactic used with seniors is to claim that a variable annuity will protect them from lawsuits or seizures of their assets. Many such claims are not based on facts, but nevertheless help land a sale.”

The North American Securities Administrators Association (NASAA), an organization of the 50 state securities regulators, warns investors to beware of “free lunch seminars” where variable annuities are often sold: “Be cautious about free lunch seminars. Although these seminars are touted as “educational,” the ultimate goal is the sale of a product. Attendees should research and examine the products and check that the promoter is licensed to sell these products. Fraud is prevalent at some seminars. Verify before you buy!”

The reputation of variable annuities has suffered from these and other associated problems and abuses. An excellent book on alternative investments, The Only Guide to Alternative Investments You’ll Ever Need, by Larry E. Swedroe and Jared Kizer, characterizes variable annuities as “bad” alternative investments and concludes: “The overwhelming evidence from academic studies on [variable annuities] is clear: In general, these products fall into the category of products that are meant to be sold, not bought. High-cost variable annuities are among the worst of traps. And for equity investors, even low-cost variable annuities will rarely make sense.”

If you have investment losses or problems involving variable annuities and equity-indexed annuities, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).