What Advisors Don’t Know About Variable Annuities: VA Mechanics

There are numerous tools available to advisors looking to help their clients chart a prudent course on the road to a comfortable retirement. An often useful but sometimes misunderstood vehicle in this regard is the variable annuity. In this and the following series of blog posts, we hope to help advisors better understand how VAs work, how to get the most out of them and where they fit in client portfolios.

If advisors have some confusion about VAs it’s not surprising. The majority of variable annuities are loaded up with all kinds of guarantees and riders, making these products both complex and expensive.

On top of that, every provider has put its own spin on the variable annuity as it strives to separate its product from those of its competitors. Those product differentiators are primarily on the surface, and once you dig down to the bedrock layer, it becomes obvious that all VAs share certain fundamental traits. Once advisors understand the mechanics, discerning the differences between competing products and fitting them into portfolios should be a much simpler process.

Many advisors have sold VAs because they have income guarantee features. These are mostly either Guaranteed Lifetime Withdrawal Benefits (GLWB) or Guaranteed Lifetime Income Benefits (GLIB). We will dive deeper into the mechanics of each type in the next two posts, but for now let’s just say that when advisors recommend VAs to their clients, many are purchased as accumulation products with retirement income a possible future option. The general idea is that one day the client will have to take that income, but in the interim, they are guaranteed a specific return annually for some number of years.  

Although many of the VAs that are now in the market were originally purchased as accumulation vehicles, for many investors it is now time to start thinking about the withdrawal side of the equation. Unfortunately, too many advisors whose clients own VAs have not really considered how the products work beyond the return guarantees and don’t really understand how all the withdrawal benefits work.

The most obvious mistake made regarding VAs is thinking that the guaranteed withdrawal rate is the same as a rate of return. A 5% lifetime GWB is not the same as a 5% yield, because for many years that withdrawal benefit is simply a return of your client’s money. At its most basic, the way a guaranteed withdrawal benefit works is that the owner of the VA is withdrawing the set percentage of the high water mark from the actual annuity account value each year and paying himself an allowance from his own money. He’s also paying the insurance company for its management of the annuity out of that same bucket of funds. The issuer of the annuity, the insurance company, doesn’t actually make any payments until all of the contract holder’s actual account value is gone.

The tax deferral benefits available through VAs may have been the primary reason that most investors purchased them, and under the right circumstances, a variable annuity can be a valuable component of a client’s portfolio. But in order to know if it’s the right vehicle for any particular client, you have to understand how they work and how to get the most out of them. Over the next few installments in this series, we will take a much deeper look at the mechanics of variable annuities, explain how GWBs and GLIBs work, the current state of VAs and how best to utilize VAs when constructing client portfolios.

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