Recently in Variable Annuities and Life Insurance Category

Found an annuity article in the local paper with an error so glaring that I had to debunk it. Here's the article:Income for Life



And here's the critical error, conveniently in the first two paragraphs:

Interested in annuities? The type known as an immediate annuity may pique the interest of some investors. But the first step is to clearly distinguish between an immediate annuity and a variable annuity.



Both are insurance products. A variable annuity is used to invest for a future need, such as financing retirement, and the benefit comes after years of compounding. An immediate annuity converts a chunk of cash into a monthly income guaranteed for life, with the payments starting right away.

BUZZ! Thank you for playing, and be sure to pick up our wonderful parting gifts. Of course you won't be any good at the home game, either.



When considering annuities there are two main categorical choices you need to make, and they are completely independent of one another, as five minutes of research would have told this person.



They two main categorical splits of annuities are immediate versus deferred, and fixed versus variable. Whatever your choice on one axis, it has nothing to do with your choice on the other axis. I can name annuity products in each category of immediate fixed, immediate variable, deferred fixed, and deferred variable.



The immediate versus deferred choice has to do with whether or you start getting monthly (or yearly) checks immediately or at some point in the future. Actually, this is a less bifurcated choice than it appears on the surface, because the difference between deferred annuities and immediate annuities is that you don't have to annuitize a deferred annuity today when you buy it - but you can annuitize it tomorrow, or you might wait fifty years or more. Annuities in general are designed to convert a fixed sum of cash into a stream of income, whether right away (immediate), or after they have received tax deferred income for some period of time, which can be days or decades (deferred).



The fixed versus variable choice has to do with where the money is invested. In fixed annuities, the money is invested in the general account of the insurance company carrying the annuity. In variable annuities, the money is invested in subaccounts that work very much like Mutual funds. I go into moderate depth of explanation of pros and cons in this article on Annuities, Fixed and Variable.



"Well, how do you annuitize a variable annuity?" you ask. You've got all of the same payoff options as a fixed annuity, of which "life with period certain" is the most common, and the most common of those are life with ten years certain, which makes payments at least ten years or however long you live, whichever is longer, life with twenty years certain (as before, except the minimum period is twenty years) and joint life with twenty-five years certain, which pays as long as either member of a couple is alive, or a minimum of twenty five years. The account balance is still invested in the subaccounts, although there is less than complete control over the full balance. Then they make use of what is called an "assumed rate of return" of which 4.5 percent is probably the most common.



"That's a rotten rate!" I hear you cry, and correct you are. Nonetheless, it not only is very little below the guaranteed return of the fixed account of the company, which varies from about five to about six percent depending upon company, recent market experience, and other factors, but it is intentionally lower than the rate of return you will most likely earn.



This means you're likely to start off with a lower payoff from the same amount of money in a variable annuity than in a fixed annuity, but the cute thing is that this is typically a minimum guaranteed payout for then and forevermore (or at least until the end of your payout period), guaranteed by the insurance company. When your actual rate of return exceeds your assumed rate of return, your payout goes up. It can subsequently go down as well if you have adverse investment results as will happen, but over time the stock and bond market have a lot more eight and twelve and twenty percent years than they do zero percent or minus five percent years. The average over time is somewhere between about ten and thirteen percent, depending upon who you ask and how you frame the question and when you ask it. So given the gap between an assumed rate of return of 4.5 percent, and actual rates of return that average somewhere about ten percent, what usually happens?



If you guessed that over time, your periodic payout tends to increase at a more than the rate of inflation, then DING! DING! DING! DING!, you win the grand prize - knowledge of how the system really works, and how you can manipulate it to your advantage. Which answers these paragraphs below from the article, wherein the author makes another error that could also have been avoided by that same five minutes of research:

Keep in mind, though, that if you live for decades, the fixed monthly income may lose buying power due to inflation. A few insurers offer products that raise payments to keep up with inflation, but they start out paying much less. A $100,000 premium might get a 65-year-old man only $464 a month, about 30 percent less than with a fixed-payment annuity.



Also, this may not be the best time to get an immediate annuity, even if one would make sense for you eventually. Interest rates are relatively low these days, keeping these products' returns low. In 1999, when rates were higher, the 65-year-old man could get a return of around 8.6 percent.

As you've just seen, payoffs for variable annuities can and do increase over time, even after annuitization. The downside is that only the original minimum payoff is guaranteed, but most folks have better experiences over time.



Now the article does have some good information in other particulars. Women receive lower payouts than men of the same age because they tend to live longer. The older you are when you annuitize, the higher the payout per month (although this can be a trivial difference if you're choosing a long period certain).



However, I cannot finish this article without mentioning the worst abuse of the public trust. The last line of the article recommends a website that I just refuse to link, among several other reasons, because they are apparently trying to sell fixed annuities only. Why? Because they are more profitable for the company and therefore pay a higher commission. I tried seven different scenarios looking for one variable annuity quote, and despite the fact that several of their listed companies offer variable annuities, got not one quote based upon a variable annuity. Variable annuities also have somewhat smaller and shorter withdrawal penalties and periods that said penalties are in effect (I should mention that most annuities will waive any withdrawal penalty if you actually annuitize). But an idiot could and should have spotted the fact that it's a commercial website looking to sell annuities rather than looking to provide information to the consumer (there isn't an online Frequently Asked Questions or any education on what an annuity is and is not, instead, you are told to call a toll free number that shills for a sales appointment), and from what I can tell, the author did all of the minimal research he did at this one website shilling for the fixed annuity industry. He would have done better to check with a few people with actual experience in both fixed and variable annuities.



In short, whereas I cannot prove that anyone was paid by the companies involved to write or print this article, in my opinion it should have been labelled an advertisement for fixed annuities.



And people trust these writers for financial advice?

Caveat Emptor

One of the most discounted investments available is the annuity.



An annuity can be thought of as the opposite of a life insurance policy. Instead of creating an lump sum of money, an annuity liquidates one by providing you instead with a stream of income.



The original idea is simple. Suppose you get a lump sum of money, and you have no immediate use for it. What's more, you think you might waste it if it's just sitting in the bank. So you decide to invest it with an insurance company, who will then pay you so much money per month, every month.



The real kicker, or reason for doing this, lies in the options for payoffs. These fall into three basic categories. Period certain, life, and life with period certain.



Period certain means you'll get payments every month for however many years. If you die, your heirs get them. When that number of years is over, so is your payout.



Life payouts equally straightforward. You (or you and your spouse in joint life payouts) get those payments every month until you die. When you die, they stop. You could get hit by a bus the next month, or live another 150 years. However long it is, the payments continue for the full amount of time, and stop as soon as your life is over.



Life with period certain means that the payments will continue for your entire life, however long that is, but there will be a period of some number of years where if you are hit by that bus, your heirs will continue to get payments. This is highly useful to people who have minor children, who are thus assured that their children will continue to get something if they die.



The idea of either of these last two options is that you have an insurance company guaranteeing that you will not outlive the income you get from this money. This can be a very psychologically comforting thing for all sorts of people in all sorts of situations, who are thereby assured that they will have something to live on.



Annuities come in two flavors of beginning, immediate and deferred. Immediate means that here is this lump sum of money, annuitize me (start sending me a monthly check) right now. Deferred means I'm investing it with you, and I may invest more with you later, but let's just let it grow for now as I don't have any immediate need for the money. You can also withdraw money from a deferred annuity without annuitizing, but the tax treatment is not as favorable (see this article)



Annuities also come in two flavors of investment, fixed and variable. Fixed annuities are merged into the general assets and liabilities of the insurance company. You invest with them, they will guarantee you a fixed return, usually somewhere in the range of four to seven percent. Of course they turn around and invest your money and usually earn about 11 percent or so, but they assume the risk. The only risk you have is that the insurance company goes completely bust, but for this reason there are several rating services for insurance companies as to financial strength. One form of fixed annuity, Equity Indexed Annuities, are very popular right now with certain segments of the financial services industry, but any guarantee you can find in any fixed annuity can be found, usually in superior form with a superior product, in variable annuities. However, sales commissions for fixed annuities are much higher, so if you go to the insurance agent on the corner, you're probably going to hear about a fixed annuity, especially if you don't shop around.



In variable annuities, you assume the investment risk while the company still furnishes the insurance component. This is done via investing them in a set of mutual fund-like sub-accounts. Once annuitized, they make use of an assumed rate of return (ARR) on the underlying investment, which is usually between four and six percent. The higher an ARR you choose, the higher your initial payout, but if the results are less than ARR your payments can usually be reduced. Most if not all companies offering variable annuities do offer a minimum payout guarantee, and if your actual rate of return exceeds the ARR, your payments will be increased (indeed, this happens more often than not, within my experience). Variable annuities require not only an insurance license, but a securities license (NASD Series 6 or Series 7) in order to sell them, and are therefore usually purchased from financial advisors. The reason is because now you are assuming investment risk. I will caution the reader that while variable annuity sales commissions are not larger than advisor's mutual funds, there is no reduction for higher investment amounts, so there may be incentive for some advisors to recommend variable annuities when mutual funds might be more appropriate. I have also seen "fee-only" planners take a fee for preparing an investment plan, then a commission for recommending these, where someone working on straight sales charge still gets the commission, but prepares the plan as "part of the package." Nonetheless, when reading articles in the financial press, especially the "self-help" financial press, there is a heavy tendency to exaggerate the downsides of variable annuities, and the hypothesis that best explains the reasoning is that variable annuities require a financial professional to work with you as an individual. If you are working with a professional you trust, you're not nearly as likely to go back to the bookstore or magazine stand for generic drivel with no fiduciary responsibility towards you. Admittedly, some advisors abuse it - and when they are caught, they are prosecuted and the insurance they are required to carry pays. The generic advice in books, newspaper, and magazines never has this responsibility in the first place. They are specifically exempted by the Investment Company Act of 1940.



I read a lot of, well, crap about variable annuity expenses. Most of it in the financial press, which should know better. How they have this expense and that expense and the other expense. The fact is that there are expenses associated with all annuities. The only additional expense that the variable annuity has that the fixed annuity does not is the expense of running the mutual fund-like sub-accounts, which actually average a bit lower than the equivalent mutual fund upon which these are usually based. Every other expense is part of every annuity - indeed, most of them are part of every insurance contract. Administration, Insurance, etcetera. They buy the stuff that makes an annuity an interesting and potentially worthwhile investment - that guarantee that you won't outlive your money, among other possibilities. But because you're dealing with something regulated by the SEC, the agent and the company have to tell you about them in variable annuities, whereas with every other insurance policy, they are a "black box" into which money goes and insurance comes out. Furthermore, variable annuities have a protection that fixed annuities do not. If the insurance company does encounter difficulty (rare for strong insurers), the variable sub-accounts are not assets of the insurance company, and cannot be attached by other creditors. They are yours.



Most companies offering annuities offer several options, depending upon what a prospective client really needs, and in what proportions. When I was in the business, the company whose variable annuities I most often sold when variable annuities were appropriate had twelve different annuities, offering this option or that option, depending upon which fit the clients needs, and they all had the same underlying subaccounts. On the other hand, I was appointed with a multitude of annuity companies, most of which I found had something to offer a certain client that was superior for that client's purposes to other offerings. Furthermore, variable annuity offerings evolve over time. I ran across a reference to one that I used to sell in its II and III editions the other day, and it's now in the VI form due to regulatory changes and a couple of product improvements.



On the pure investment scale, variable annuities have two significant upsides and one significant downside as opposed to mutual funds. The downside is easiest to explain. As previously discussed, they have a so-called "MIE" expense and charge ratio that goes from about one and a quarter to one and two-thirds percent per year (although some designed for asset-based management fees go as low as forty basis points), as opposed to 12-b-1 fees for most mutual funds are about a quarter of a percent per year.



The first upside is the fact that all monies invested in an annuity earn money tax deferred. This means that you're not paying taxes on money invested in annuities as you go, only when you withdraw it. This has the minor downside associated that it's all ordinary income, none of it capital gains, and capital gains may be taxed at a lower rate. Nonetheless, because you're not losing a fraction of your gains, you are earning interest on your taxes for those years until it's time to pay, as opposed to paying taxes on your earnings, after which they are gone. Depending upon various assumptions, this direct trade-off between higher MIE charges and deferred taxes will have a mutual fund theoretically leading an equivalent variable annuity sub-account for about fifteen years (I can get results varying from ten years to twenty-two without unduly torturing the assumptions), after which the variable annuity sub-account (net after taxes and redemption) will take the lead. This does not take into account investment re-balancing, which would work in favor of the variable annuity sub-account, as moving money between those has no tax consequences, something that mutual funds cannot say.



On the other hand, if you're talking about money that is tax-deferred by definition, such as IRA, Roth IRA, and many other sorts, the variable annuity sub-account does not gain the the benefit of the first advantage I just listed, as it is already present. Nonetheless, many very smart people nonetheless have tax deferred money in variable annuity subaccounts. Why? That's the second upside I was going to mention. Because the managers of mutual funds have to sometimes make decisions for the fund based upon tax consequences to shareholders, as opposed to strictly what's the smartest thing to do, investment-wise, as a large proportion of their shareholders investment dollars are not tax-deferred. But every last dollar invested in variable annuity subaccounts is tax deferred. So variable annuity subaccounts will usually outperform the equivalent mutual fund as far as investment return. I've seen estimates that range anywhere from fifty basis points to 150 basis points (0.5% to 1.5%) per year for the average of this number, depending upon who is doing the estimating. Given the 100 to 140 basis point difference in MIE vs. 12-b-1 charges, considered as a pure investment, this aspect of variable annuity subaccounts is likely to fall short of mutual fund returns considered from a strict "how many dollars do you end up with?" standpoint. Note, however, that the MIE buys some guarantees (insurance) in the areas of minimum returns, locking in high investment values, lifetime payouts, etcetera, which mutual fund 12-b-1 fees do not. If you're prepared to undertake a lot more risks, mutual funds will probably (but only probably) come out ahead. If you want some guarantees, the variable annuity sub-account has a lot to be said for it. I know of many people who were looking to retire based upon mutual fund account balances in 1999, who are still down major percentages of what their portfolio value was then. If they had invested in a variable annuity, that 1999 value might have only been 99 percent of the mutual fund value, but they would still have every penny of it and then some.



Caveat Emptor.

Asymmetrical Information has a good article about the political and budget problems faced by pensions everywhere. It touches upon the treatment of annuities, one of the most popular investment vehicles there is. Most defined contribution pensions (e.g. 401k, among others) in the United States are actually funded by variable annuities.



Annuities currently have in interesting tax status, and there are several kinds. They are certainly popular instruments and their tax deferred status gives them appeal to many investors. For this purpose however, I am going to restrict myself to the question of whether or not they have been annuitized, which is the actual process of exchanging a pool of dollars that you control for a stream of income.



If the annuity has not been annuitized, it is taxed on a "Last In First Out" or LIFO basis. What this means is that the dollars that come out are presumed to be from the most recent that went in. In other words, insofar as possible, it is the original principal that is untouched and the earned income you are using. So if you put $100,000 in (assuming the money is "after tax" as many people have annuities with "before tax" money involved), as long as the balance remains over $100,000 you are assumed to be withdrawing earnings and every penny is taxable. Only after you have depleted the annuity account below $100,000 are you presumed to be using your contributed money. Note that every dollar of contributed money you use lowers this threshold, or "basis" in the account. If you take $20,000 of the original money, your basis is now $80,000, and this is the new threshold value. Note that basis can also be increased by subsequent contributions.



If you annuitize the pool of dollars by exchanging it for a stream of income, there are implications brought on by the fact that you no longer own the pool. The first of these is that the exchange is irrevocable. It doesn't go backwards. You can certainly exchange the stream of income for another pool of dollars now, but expect the pool to be smaller than it was as both exchanges have made the insurance company offering them a profit.



But because the exchange is irrevocable, the IRS will treat it somewhat more favorably. What they will do is take an actuarial treatment of how long you are expected to live, and then make a determination based upon that of how much of each month's payment is interest and therefore taxable, and how much is a return of principal, and therefore not taxable in most cases. If you outlive your actuarial expectation the whole thing becomes taxable. If you annuitized a before tax account like a traditional IRA or 401k, the whole computation is moot, of course.



The implications are fairly obvious. In general, an annuity is not an account you should "protect" by drawing down other accounts instead. Indeed, annuities should probably be near the head of the list of accounts that you should should draw down and/or use to exchange value for something else that is largely tax free, like cash value life insurance or Roth accounts, lest there be a large tax liability upon your death. It also takes about fifteen years, plus or minus, for a variable annuity's tax deferred status to pay for itself as opposed to other investments which are not inherently tax deferred, such as mutual funds. There are very strong arguments for placing even tax deferred accounts in variable annuities, but this article is not the place for them, and you should understand both sides before making a decision.



Nonetheless, thanks to Asymmetrical Information for giving me the idea for an article.



Caveat Emptor

Found an annuity article in the local paper with an error so glaring that I had to debunk it. Here's the article:Income for Life



And here's the critical error, conveniently in the first two paragraphs:

Interested in annuities? The type known as an immediate annuity may pique the interest of some investors. But the first step is to clearly distinguish between an immediate annuity and a variable annuity.



Both are insurance products. A variable annuity is used to invest for a future need, such as financing retirement, and the benefit comes after years of compounding. An immediate annuity converts a chunk of cash into a monthly income guaranteed for life, with the payments starting right away.

BUZZ! Thank you for playing, and be sure to pick up our wonderful parting gifts. Of course you won't be any good at the home game, either.



When considering annuities there are two main categorical choices you need to make, and they are completely independent of one another, as five minutes of research would have told this person.



They two main categorical splits of annuities are immediate versus deferred, and fixed versus variable. Whatever your choice on one axis, it has nothing to do with your choice on the other axis. I can name annuity products in each category of immediate fixed, immediate variable, deferred fixed, and deferred variable.



The immediate versus deferred choice has to do with whether or you start getting monthly (or yearly) checks immediately or at some point in the future. Actually, this is a less bifurcated choice than it appears on the surface, because the difference between deferred annuities and immediate annuities is that you don't have to annuitize a deferred annuity today when you buy it - but you can annuitize it tomorrow, or you might wait fifty years or more. Annuities in general are designed to convert a fixed sum of cash into a stream of income, whether right away (immediate), or after they have received tax deferred income for some period of time, which can be days or decades (deferred).



The fixed versus variable choice has to do with where the money is invested. In fixed annuities, the money is invested in the general account of the insurance company carrying the annuity. In variable annuities, the money is invested in subaccounts that work very much like Mutual funds. I go into moderate depth of explanation of pros and cons in this article on Annuities, Fixed and Variable.



"Well, how do you annuitize a variable annuity?" you ask. You've got all of the same payoff options as a fixed annuity, of which "life with period certain" is the most common, and the most common of those are life with ten years certain, which makes payments at least ten years or however long you live, whichever is longer, life with twenty years certain (as before, except the minimum period is twenty years) and joint life with twenty-five years certain, which pays as long as either member of a couple is alive, or a minimum of twenty five years. The account balance is still invested in the subaccounts, although there is less than complete control over the full balance. Then they make use of what is called an "assumed rate of return" of which 4.5 percent is probably the most common.



"That's a rotten rate!" I hear you cry, and correct you are. Nonetheless, it not only is very little below the guaranteed return of the fixed account of the company, which varies from about five to about six percent depending upon company, recent market experience, and other factors, but it is intentionally lower than the rate of return you will most likely earn.



This means you're likely to start off with a lower payoff from the same amount of money in a variable annuity than in a fixed annuity, but the cute thing is that this is typically a minimum guaranteed payout for then and forevermore (or at least until the end of your payout period), guaranteed by the insurance company. When your actual rate of return exceeds your assumed rate of return, your payout goes up. It can subsequently go down as well if you have adverse investment results as will happen, but over time the stock and bond market have a lot more eight and twelve and twenty percent years than they do zero percent or minus five percent years. The average over time is somewhere between about ten and thirteen percent, depending upon who you ask and how you frame the question and when you ask it. So given the gap between an assumed rate of return of 4.5 percent, and actual rates of return that average somewhere about ten percent, what usually happens?



If you guessed that over time, your periodic payout tends to increase at a more than the rate of inflation, then DING! DING! DING! DING!, you win the grand prize - knowledge of how the system really works, and how you can manipulate it to your advantage. Which answers these paragraphs below from the article, wherein the author makes another error that could also have been avoided by that same five minutes of research:

Keep in mind, though, that if you live for decades, the fixed monthly income may lose buying power due to inflation. A few insurers offer products that raise payments to keep up with inflation, but they start out paying much less. A $100,000 premium might get a 65-year-old man only $464 a month, about 30 percent less than with a fixed-payment annuity.



Also, this may not be the best time to get an immediate annuity, even if one would make sense for you eventually. Interest rates are relatively low these days, keeping these products' returns low. In 1999, when rates were higher, the 65-year-old man could get a return of around 8.6 percent.

As you've just seen, payoffs for variable annuities can and do increase over time, even after annuitization. The downside is that only the original minimum payoff is guaranteed, but most folks have better experiences over time.



Now the article does have some good information in other particulars. Women receive lower payouts than men of the same age because they tend to live longer. The older you are when you annuitize, the higher the payout per month (although this can be a trivial difference if you're choosing a long period certain).



However, I cannot finish this article without mentioning the worst abuse of the public trust. The last line of the article recommends a website that I just refuse to link, among several other reasons, because they are apparently trying to sell fixed annuities only. Why? Because they are more profitable for the company and therefore pay a higher commission. I tried seven different scenarios looking for one variable annuity quote, and despite the fact that several of their listed companies offer variable annuities, got not one quote based upon a variable annuity. Variable annuities also have somewhat smaller and shorter withdrawal penalties and periods that said penalties are in effect (I should mention that most annuities will waive any withdrawal penalty if you actually annuitize). But an idiot could and should have spotted the fact that it's a commercial website looking to sell annuities rather than looking to provide information to the consumer (there isn't an online Frequently Asked Questions or any education on what an annuity is and is not, instead, you are told to call a toll free number that shills for a sales appointment), and from what I can tell, the author did all of the minimal research he did at this one website shilling for the fixed annuity industry. He would have done better to check with a few people with actual experience in both fixed and variable annuities.



In short, whereas I cannot prove that anyone was paid by the companies involved to write or print this article, in my opinion it should have been labeled an advertisement for fixed annuities.



And people trust these writers for financial advice?

One of the most discounted investments available is the annuity.



An annuity can be thought of as the opposite of a life insurance policy. Instead of creating an lump sum of money, an annuity liquidates one by providing you instead with a stream of income.



The original idea is simple. Suppose you get a lump sum of money, and you have no immediate use for it. What's more, you think you might waste it if it's just sitting in the bank. So you decide to invest it with an insurance company, who will then pay you so much money per month, every month.



The real kicker, or reason for doing this, lies in the options for payoffs. These fall into three basic categories. Period certain, life, and life with period certain.



Period certain means you'll get payments every month for however many years. If you die, your heirs get them. When that number of years is over, so is your payout.



Life payouts equally straightforward. You (or you and your spouse in joint life payouts) get those payments every month until you die. When you die, they stop. You could get hit by a bus the next month, or live another 150 years. However long it is, the payments continue for the full amount of time, and stop as soon as your life is over.



Life with period certain means that the payments will continue for your entire life, however long that is, but there will be a period of some number of years where if you are hit by that bus, your heirs will continue to get payments. This is highly useful to people who have minor children, who are thus assured that their children will continue to get something if they die.



The idea of either of these last two options is that you have an insurance company guaranteeing that you will not outlive the income you get from this money. This can be a very psychologically comforting thing for all sorts of people in all sorts of situations, who are thereby assured that they will have something to live on.



Annuities come in two flavors of beginning, immediate and deferred. Immediate means that here is this lump sum of money, annuitize me (start sending me a monthly check) right now. Deferred means I'm investing it with you, and I may invest more with you later, but let's just let it grow for now as I don't have any immediate need for the money. You can also withdraw money from a deferred annuity without annuitizing, but the tax treatment is not as favorable (see this article)



Annuities also come in two flavors of investment, fixed and variable. Fixed annuities are merged into the general assets and liabilities of the insurance company. You invest with them, they will guarantee you a fixed return, usually somewhere in the range of four to seven percent. Of course they turn around and invest your money and usually earn about 11 percent or so, but they assume the risk. The only risk you have is that the insurance company goes completely bust, but for this reason there are several rating services for insurance companies as to financial strength. One form of fixed annuity, Equity Indexed Annuities, are very popular right now with certain segments of the financial services industry, but any guarantee you can find in any fixed annuity can be found, usually in superior form with a superior product, in variable annuities. However, sales commissions for fixed annuities are much higher, so if you go to the insurance agent on the corner, you're probably going to hear about a fixed annuity, especially if you don't shop around.



In variable annuities, you assume the investment risk while the company still furnishes the insurance component. This is done via investing them in a set of mutual fund-like sub-accounts. Once annuitized, they make use of an assumed rate of return (ARR) on the underlying investment, which is usually between four and six percent. The higher an ARR you choose, the higher your initial payout, but if the results are less than ARR your payments can usually be reduced. Most if not all companies offering variable annuities do offer a minimum payout guarantee, and if your actual rate of return exceeds the ARR, your payments will be increased (indeed, this happens more often than not, within my experience). Variable annuities require not only an insurance license, but a securities license (NASD Series 6 or Series 7) in order to sell them, and are therefore usually purchased from financial advisors. The reason is because now you are assuming investment risk. I will caution the reader that while variable annuity sales commissions are not larger than advisor's mutual funds, there is no reduction for higher investment amounts, so there may be incentive for some advisors to recommend variable annuities when mutual funds might be more appropriate. I have also seen "fee-only" planners take a fee for preparing an investment plan, then a commission for recommending these, where someone working on straight sales charge still gets the commission, but prepares the plan as "part of the package." Nonetheless, when reading articles in the financial press, especially the "self-help" financial press, there is a heavy tendency to exaggerate the downsides of variable annuities, and the hypothesis that best explains the reasoning is that variable annuities require a financial professional to work with you as an individual. If you are working with a professional you trust, you're not nearly as likely to go back to the bookstore or magazine stand for generic drivel with no fiduciary responsibility towards you. Admittedly, some advisors abuse it - and when they are caught, they are prosecuted and the insurance they are required to carry pays. The generic advice in books, newspaper, and magazines never has this responsibility in the first place. They are specifically exempted by the Investment Company Act of 1940.



I read a lot of, well, crap about variable annuity expenses. Most of it in the financial press, which should know better. How they have this expense and that expense and the other expense. The fact is that there are expenses associated with all annuities. The only additional expense that the variable annuity has that the fixed annuity does not is the expense of running the mutual fund-like sub-accounts, which actually average a bit lower than the equivalent mutual fund upon which these are usually based. Every other expense is part of every annuity - indeed, most of them are part of every insurance contract. Administration, Insurance, etcetera. They buy the stuff that makes an annuity an interesting and potentially worthwhile investment - that guarantee that you won't outlive your money, among other possibilities. But because you're dealing with something regulated by the SEC, the agent and the company have to tell you about them in variable annuities, whereas with every other insurance policy, they are a "black box" into which money goes and insurance comes out. Furthermore, variable annuities have a protection that fixed annuities do not. If the insurance company does encounter difficulty (rare for strong insurers), the variable sub-accounts are not assets of the insurance company, and cannot be attached by other creditors. They are yours.



Most companies offering annuities offer several options, depending upon what a prospective client really needs, and in what proportions. When I was in the business, the company whose variable annuities I most often sold when variable annuities were appropriate had twelve different annuities, offering this option or that option, depending upon which fit the clients needs, and they all had the same underlying subaccounts. On the other hand, I was appointed with a multitude of annuity companies, most of which I found had something to offer a certain client that was superior for that client's purposes to other offerings. Furthermore, variable annuity offerings evolve over time. I ran across a reference to one that I used to sell in its II and III editions the other day, and it's now in the VI form due to regulatory changes and a couple of product improvements.



On the pure investment scale, variable annuities have two significant upsides and one significant downside as opposed to mutual funds. The downside is easiest to explain. As previously discussed, they have a so-called "MIE" expense and charge ratio that goes from about one and a quarter to one and two-thirds percent per year (although some designed for asset-based management fees go as low as forty basis points), as opposed to 12-b-1 fees that for most mutual funds are about a quarter of a percent per year.



The first upside is the fact that all monies invested in an annuity earn money tax deferred. This means that you're not paying taxes on money invested in annuities as you go, only when you withdraw it. This has the minor downside associated that it's all ordinary income, none of it capital gains, and capital gains may be taxed at a lower rate. Nonetheless, because you're not losing a fraction of your gains, you are earning interest on your taxes for those years until it's time to pay, as opposed to paying taxes on your earnings, after which they are gone. Depending upon various assumptions, this direct trade-off between higher MIE charges and deferred taxes will have a mutual fund theoretically leading an equivalent variable annuity sub-account for about fifteen years (I can get results varying from ten years to twenty-two without unduly torturing the assumptions), after which the variable annuity sub-account (net after taxes and redemption) will take the lead. This does not take into account investment re-balancing, which would work in favor of the variable annuity sub-account, as moving money between those has no tax consequences, something that mutual funds cannot say.



On the other hand, if you're talking about money that is tax-deferred by definition, such as IRA, Roth IRA, and many other sorts, the variable annuity sub-account does not gain the the benefit of the first advantage I just listed, as it is already present. Nonetheless, many very smart people nonetheless have tax deferred money in variable annuity subaccounts. Why? That's the second upside I was going to mention. Because the managers of mutual funds have to sometimes make decisions for the fund based upon tax consequences to shareholders, as opposed to strictly what's the smartest thing to do, investment-wise, as a large proportion of their shareholders investment dollars are not tax-deferred. But every last dollar invested in variable annuity subaccounts is tax deferred. So variable annuity subaccounts will usually outperform the equivalent mutual fund as far as investment return. I've seen estimates that range anywhere from fifty basis points to 150 basis points (0.5% to 1.5%) per year for the average of this number, depending upon who is doing the estimating. Given the 100 to 140 basis point difference in MIE vs. 12-b-1 charges, considered as a pure investment, this aspect of variable annuity subaccounts is likely to fall short of mutual fund returns considered from a strict "how many dollars do you end up with?" standpoint. Note, however, that the MIE buys some guarantees (insurance) in the areas of minimum returns, locking in high investment values, lifetime payouts, etcetera, which mutual fund 12-b-1 fees do not. If you're prepared to undertake a lot more risks, mutual funds will probably (but only probably) come out ahead. If you want some guarantees, the variable annuity sub-account has a lot to be said for it. I know of many people who were looking to retire based upon mutual fund account balances in 1999, who are still down major percentages of what their portfolio value was then. If they had invested in a variable annuity, that 1999 value might have only been 99 percent of the mutual fund value, but they would still have every penny of it and then some.



Caveat Emptor.

Asymmetrical Information has a good article about the political and budget problems faced by pensions everywhere. It touches upon the treatment of annuities, one of the most popular investment vehicles there is. Most defined contribution pensions (e.g. 401k, among others) in the United States are actually funded by variable annuities.



Annuities currently have in interesting tax status, and there are several kinds. They are certainly popular instruments and their tax deferred status gives them appeal to many investors. For this purpose however, I am going to restrict myself to the question of whether or not they have been annuitized, which is the actual process of exchanging a pool of dollars that you (basically) control for a stream of income.



If the annuity has not been annuitized, it is taxed on a "Last In First Out" or LIFO basis. What this means is that the dollars that come out are presumed to be from the most recent that went in. In other words, insofar as possible, it is the original principal that is untouched and the earned income you are using. So if you put $100,000 in (assuming the money is "after tax" as many people have annuities with "before tax" money involved), as long as the balance remains over $100,000 you are assumed to be withdrawing earnings and every penny is taxable. Only after you have depleted the annuity account below $100,000 are you presumed to be using your contributed money. Note that every dollar of contributed money you use lowers this threshold, or "basis" in the account. If you take $20,000 of the original money, your basis is now $80,000, and this is the new threshold value. Note that basis can also be increased by subsequent contributions.



If you annuitize the pool of dollars by exchanging it for a stream of income, there are implications brought on by the fact that you no longer own the pool. The first of these is that the exchange is irrevocable. It doesn't go backwards. You can certainly exchange the stream of income for another pool of dollars now, but expect the pool to be smaller than it was as both exchanges have made the insurance company offering them a profit.



But because the exchange is irrevocable, the IRS will treat it somewhat more favorably. What they will do is take an actuarial treatment of how long you are expected to live, and then make a determination based upon that of how much of each month's payment is interest and therefore taxable, and how much is a return of principal, and therefore not taxable in most cases. If you outlive your actuarial expectation the whole thing becomes taxable. If you annuitized a before tax account like a traditional IRA or 401k, the whole computation is moot, of course.



The implications are fairly obvious. In general, an annuity is not an account you should "protect" by drawing down other accounts instead. Indeed, annuities should probably be near the head of the list of accounts that you should should draw down and/or use to exchange value for something else that is largely tax free, like life insurance or Roth accounts, lest there be a large tax liability upon your death. It also takes about fifteen years for a variable annuity's tax deferred status to pay for itself as opposed to other investments which are not inherently tax deferred, such as mutual funds. There are very strong arguments for placing even tax deferred accounts in variable annuities, but this article is not the place for them, and you should understand both sides before making a decision.



Nonetheless, thanks to Asymmetrical Information for giving me the idea for an article.