Chapter 5 — Annuity Suitability (continued)

Variable annuities are typically viewed as an alternative to mutual funds or equities. (This discussion assumes that the investor in the variable annuity elects to invest in equity-based subaccounts. For variable annuity owners who choose to invest in the contract’s fixed account, the annuity will behave more like the fixed annuities described in the previous section.) Some variable contracts offer “clones” of popular mutual funds as their investment subaccounts — so this comparison seems to make sense at a superficial level. There are, however, substantial differences that may make variable annuities more (or less) suitable than mutual funds or stocks.

Income Taxation

One of the prime advantages of investing in a variable annuity, as opposed to stocks or mutual funds, is that earnings in the annuity grow tax-deferred. The investor also has the opportunity of “timing” withdrawals to take advantage of lower tax brackets or net the annuity earnings against other ordinary income losses the investor may incur in a particular year. Another advantage is that the tax-deferred growth within the account is not included in calculating the AMT or determining whether Social Security benefits will be taxed. A disadvantage is that deferred variable annuities are subject to a 10% penalty on withdrawals prior to age 59½.

There is another significant tax disadvantage. All withdrawals taken from a variable annuity will be taxed as ordinary income. By contrast, an investor purchasing shares of stock that appreciate in value will be taxed, when the stock is sold, at a reduced capital gains rate. Mutual funds must distribute any realized capital appreciation annually, but this too will be taxed as capital gains, not ordinary income. Qualified dividend income received from a stock portfolio or mutual fund will be taxed more favorably than ordinary income.

The central tax question for the investor is: Will the accelerated tax-deferred growth (“triple compounding”) available under the variable annuity more than compensate for the higher tax rate applied to that growth when it is withdrawn? The answer depends on the investor’s current tax rate, the anticipated tax rate that will apply when the withdrawal is taken, and how long the earnings will grow tax-deferred. Advisors should try to project which investment vehicle (variable annuity or mutual fund) will yield the greater after-tax net income to the client.

If the annuity is annuitized rather than taken as a lump sum withdrawal, the tax-deferred growth continues to be earned even during the annuity period — and depending on how long the annuity period lasts, continued tax-deferral can add significantly to the value accumulated by, and ultimately distributed to, the contractholder.

Estate Taxation

There is an important estate tax difference between variable annuities and mutual funds. Upon death, beneficiaries inherit most securities — such as stock and mutual funds — at a “stepped-up basis.” This is not the case with variable annuities. Beneficiaries who inherit a variable annuity also inherit the original owner’s cost basis.

For investors focused on the efficient transfer of wealth to the next generation, variable annuities may not be as suitable as other comparable investments.

Death Benefit

Deferred variable annuities offer a minimum guaranteed death benefit that mutual funds or other securities cannot match. In most variable contracts, the minimum guaranteed death benefit is the greater of initial contributions or the current contract value at the time of death. If the value of the subaccount falls and the contractholder dies, heirs will be guaranteed the contractholder’s principal — something a comparable mutual fund that declined in value could not provide.

But that protection comes at a cost: a mortality expense is assessed against the contract. And the protection is only of value in the case of a market decline — if the account value at death exceeds the original investment, heirs receive that increased value, the same as they would have received from a comparable mutual fund. In effect, the variable annuity’s insurance component provides no extra value if the subaccount grows.

Consider the alternative: if the contractholder had purchased a life insurance policy and invested in a comparable mutual fund, upon death the heirs would receive the current value of the fund shares plus the life insurance proceeds. Assuming the life insurance proceeds exceed any decline in share value, heirs would see a greater inheritance than the minimum guaranteed death benefit of the variable annuity — and if the fund value increased, they’d receive that increased value plus the life insurance proceeds.

The mortality charge is typically assessed as a percentage of account value, usually 10–30 basis points (0.10–0.30%) per year. As the account value grows, so does the mortality charge — yet as noted, the minimum death benefit is only of value when the account has fallen. So the contractholder pays more in mortality charges precisely as the guaranteed death benefit becomes less valuable. Some annuity companies now base the mortality charge on the actual risk undertaken by the company to address this illogical outcome.

The mortality charge should ultimately be viewed as a risk management decision. For some investors, the protection provided to their heirs may be well worth the cost. For others not particularly concerned with maximizing wealth transfer, mortality charges simply act as a drag on investment performance — and a comparable mutual fund might be more suitable.

Enhanced death benefits — which ratchet up the minimum death benefit based on either a fixed rate of growth or actual subaccount performance — are available in some contracts at additional cost. In periods of great market volatility, these enhanced benefits may well be worth their price. Advisors should analyze the tradeoff.

Enhanced Living Benefits

Newly-issued variable annuity contracts offer many enhanced living benefits: GMIBs, GMABs, and GMWBs, or possibly provisions that include all of these in one package (all discussed in detail in Chapter 1). All come at an additional charge and provide levels of protection not available to investors in a comparable mutual fund.

The question for the investor and advisor is whether the benefits justify the additional cost — approached the same way as the death benefit: as a risk management decision. If the contractholder is not interested in the protection these provisions offer, the additional cost simply acts as a drag on investment performance. If the contractholder values the risk protection, the question becomes: Is that value worth the cost? The cost is usually stated clearly in the contract; the actual value for each prospective contractholder is more difficult to assess.

Some annuity companies offer training seminars to provide advisors with the tools necessary to evaluate these benefits. At a minimum, advisors should thoroughly study all marketing materials and contract language to better explain the true value of these benefits to clients. For risk-averse clients, the peace of mind these benefits offer may more than justify the cost.

Surrender Charges

Most deferred annuities impose a surrender charge on large withdrawals in the first years of the contract’s life, making annuities a less-than-liquid investment option compared to mutual funds. Surrender charges cover the upfront acquisition costs incurred by annuity companies, primarily commissions to sales personnel. Some deferred variable annuities offer the investor the option of an upfront sales charge (Class A shares) or a contract with surrender charges (Class B shares).

Mutual funds have the same type of expenses to cover: many impose either an upfront “load” or a back-end load (similar to surrender charges on variable annuities). To avoid these costs entirely, an investor could opt for direct investment in individual equities or no-load mutual funds.

Investment Fees

Both mutual funds and variable annuity subaccounts are actively managed portfolios and both charge a fee to cover the management expense. While a subaccount may be managed by a mutual fund company and even share its name, there may be differences in management fees. Typically, management fees are higher on subaccounts invested in industry-specific portfolios or portfolios invested in less liquid assets (e.g., real estate); lower on broadly diversified portfolios. The fixed subaccount that pays a fixed rate of return usually does not charge a management fee. Knowledgeable investors could avoid or minimize these annual charges by investing in and holding a portfolio of individual securities.

Income Payments

Annuities are the only investment option that can guarantee a lifetime income, regardless of the length of the measuring life. The periodic income stream from an annuity is part principal and part earnings (and therefore only partly taxable). Income streams from other investments, such as dividends and interest, are fully taxable and never guaranteed to last for a lifetime.

Many deferred annuities are never annuitized — they are used to meet accumulation, not distribution, objectives. That said, all variable annuity contracts do offer guaranteed payout options, an opportunity not available in other investment vehicles. Of course, other investment alternatives may be used to accumulate wealth, and if periodic lifetime income is eventually needed, that investment can be liquidated and used to purchase an immediate annuity.

Equity indexed annuities (EIAs) — with their guaranteed minimum rate of return and market-derived interest rates — fit somewhere between traditional fixed annuities and variable annuities. Advisors would be best served by viewing equity indexed annuities as a fixed annuity with a fixed rate of return; if market returns eventually exceed that minimum, that’s additional upside for the client.

Many commentators view EIAs as an alternative to indexed mutual funds or ETFs — but the comparisons are not entirely valid. There are four key distinctions:

EIA Liquidity & the Laddering Strategy

As with all annuities, EIAs impose surrender charges. EIAs are primarily a vehicle for accumulation, and investors should plan to hold the contract for the full stated maturity. Withdrawals prior to maturity can have serious adverse consequences to the actual return earned — in some contracts, the equity-based rate of return is applied only to contracts that remain in force until maturity, and the surrender value of early-exiting contracts is based on only the minimum guaranteed rate, not the indexed value. This makes EIAs particularly illiquid.

Advisors can partially overcome this illiquidity by “laddering” the maturity dates — the same technique used with a bond portfolio. Instead of investing the full amount in one contract with one maturity date, the investor could purchase several equity indexed annuities with progressively longer maturity dates: