Best Variable Annuity Strategies

Investors continue to pour money into variable annuities, many for the wrong reasons. It’s easy to understand why. Variable annuities are complicated. They also pay high commissions, encouraging strong sales efforts.

Perhaps that is why about 14% of IRA-owners have all or part of their IRAs in variable annuities. Or why 11% of variable annuities pay fixed returns. Or why about half of variable annuities are sold to people over age 65. Let’s look at why these are mistakes, and how you can maximize the benefits of a Variable Annuity.

A variable annuity is a group of mutual funds in a tax-deferred annuity, with some life insurance attached. You choose how your account is invested among the funds offered by the insurer. All income and gains are tax-free in the annuity, and they are taxed as ordinary income only when distributed. A variable annuity also has a life insurance feature that ensures your beneficiary won’t receive less money than you initially invested.

If the variable annuity provides tax-deferral, why buy it through IRAs, which also are tax-deferred? Why not simply buy mutual funds directly through IRAs?

One explanation is the insurance protection. If your annuity investments lose value after you buy them, your beneficiary is guaranteed at least the amount you originally invested. But this protection is overstated. The odds of your dying while the investments are below the initial purchase price are very low. The amount insurers pay on this insurance provision is reported to be statistically insignificant. In addition, the cost of that insurance is quite high. That is one of the reasons why the annual expenses on variable annuities average 2.1% while annual expenses on mutual funds average 1.4%. It is much cheaper to buy term insurance for a few years until the investments are comfortably above your purchase price.

Another supposed advantage of the variable annuity in an IRA is that you can “annuitize” it. That means when you are ready to take withdrawals, you can convert the annuity to a stream of fixed payments that are guaranteed to last the rest of your life or a period of years, whichever you select.

If you own mutual funds in an IRA and want a steady stream of guaranteed income, you can sell the mutual funds and buy an annuity contract. You’ll be able to shop around for the best annuitization deal available. A variable annuity might guarantee a minimum annuitization rate, but you don’t know if that rate will be attractive in the future.

Sales of variable annuities to IRAs are considered so questionable that the NASD, which regulates brokers who sell variable annuities, recently issued new guidelines. The brokers have to inform buyers that the tax deferral of the annuity is not needed in the IRA. The brokers also have to prove that the life insurance and annuitization features warrant buying the variable annuity in the IRA.

What about buying fixed interest investments through variable annuities? If you invest for 5% to 6% interest (or less), expenses of 2% or more take a major portion of your return. You might be able to get a better after-tax and after-expense return from a interest-paying bank checking account. The lower the return you expect from an investment, the less sense a variable annuity makes.

You need more than a high return to justify buying a variable annuity. You also need time – a long time. That brings us to those over age 65 buying variable annuities.
Variable annuities have two big disadvantages. One is the high expenses. The other is that all your gains are taxed to you as ordinary income, even if they are long-term capital gains within the annuity.

My research, which is backed by the research of others, shows that if you buy a low-expense variable annuity you have to let the gains compound for at least 10 years to overcome the disadvantages. Low expense annuities generally are those offered by mutual fund companies (Vanguard has the lowest expenses) or discount brokers (such as Charles Schwab & Co.).

If you buy an average expense annuity, you need at least 15 years of compounding to get the same net return that you’d get from investing in low-tax stocks or mutual funds outside the annuity. The exact break-even point for the annuity depends on the turnover and annual taxes in the taxable account.

If you buy stocks, or mutual funds with low annual distributions, and hold them for many years, it would take the annuity more than 15 years to beat the taxable account.

Estate taxes are an overlooked disadvantage of variable annuities. Suppose you let the annuity accumulate gains tax-deferred for your heirs. On your death, the annuity is included in your estate and subject to estate taxes with the rest of your property. Then, when your beneficiary withdraws earnings from the annuity, it is taxed at ordinary income tax rates. If the maximum tax is imposed at both stages, the IRS gets about 80% of your annuity’s value.

Mutual funds also would be included in your estate. But your heirs would get to increase the tax basis of the funds to their fair market value on your death. Then they could sell the funds and incur no taxes. No one would pay capital gains taxes on the appreciation during your lifetime.

This doesn’t mean there is not a place for variable annuities in a portfolio.

First, be sure you have maximized the use of other tax-deferred vehicles, such as IRAs and 401(k)s. Also maximize use of the tax-free Roth IRA.

Second, review your investment strategy. If you will invest for safety, consider a fixed annuity, tax-free bonds, or regular bond funds instead. If you will buy and hold quality stocks or stock mutual funds for a long time, you probably are better off outside an annuity. If you frequently will sell a fund after less than a year or will seek out top-performing funds and sell them after substantial gains, then a variable annuity might be for you.

Third, determine when you might need the money. If you won’t need or want it for 10 or 15 years, consider a variable annuity. Also, be sure you won’t need it before age 59 1/2. Otherwise, you’ll owe a 10% penalty tax in addition to regular income taxes if you withdraw it from an annuity..

Fourth, if you are confident of being in a lower-tax bracket when withdrawals are made than you are now, a variable annuity becomes more attractive.
Fifth, check out fees and expenses. In an average annuity, there will be annual mortality and administrative expenses of over 2% of the account and an annual fee of about $25. The lowest expenses are charged by the Vanguard Variable Annuity and by TIAA-CREF. Of the two, Vanguard offers more investment options. Schwab offers more options for slightly higher expenses.

Take a good look at surrender charges. Many annuities charge 7% or more if you want your money back early. Often surrender charges continue on a declining scale for seven to 10 years. Vanguard, TIAA-CREF, and other mutual funds companies have no surrender charges.