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September 09, 2001 at 08:00 PM
A Variable Annuity Inside An IRA? Educate Clients, Let Them Choose
By
The debate over whether it makes sense to use a variable annuity inside an Individual Retirement Account (IRA) has gone on within the financial community as long as the historical feud between the Hatfields and the McCoys.
While neither side of this issue may ever be able to claim victory, continued debate should serve to provide the professional financial community with perspectives around this topic that will ultimately benefit clients that advisors assist in making decisions.
The basis of any financial decision with respect to the utilization of an investment product needs to be based on suitability–the understanding of our clients investment needs to determine the most appropriate investment solution. Not until we understand our clients current financial position, their risk tolerance, time horizon, financial goals, and comfort level with investments they currently own, or have owned in the past, will we be in a good position to make sound investment decisions going forward.
For the average investor who desires equity exposure yet doesnt have the assets needed to develop a well-diversified portfolio of individual stock, it would be difficult to make the argument that a mutual fund isnt an acceptable investment vehicle to fund an IRA. A mutual fund provides an investor with several benefits, including diversification, professional money management and marketability.
I use marketability here in place of liquidity because, in theory, liquidity is the ability to sell an investment and receive back the amount you invested in the asset, plus interest at any time with no risk to value. Marketability, however, is having the ability to sell your investment at any time, but not necessarily at the same price at which the asset was acquired.
The availability of this attractive combination of features contained within one product is the reason mutual funds have become such a popular investment vehicle over the past 15 to 20 years.
The investment element of a variable annuity is referred to as a “subaccount.” Subaccounts offer the identical investment features of a mutual fund: professional management, diversification and marketability. However, the VA chassis within which subaccounts lie also offers other features and corresponding benefits that are not available in mutual funds. These would include, but not be limited to: tax deferral, a guaranteed income for life, and a guaranteed death benefit.
Since we are talking about owning this investment within an IRA, the benefit of tax deferral that is available through the purchase of a VA is irrelevant. It is the IRA account type that will dictate the tax benefits or potential negative tax consequences, such as penalties for early withdrawals, of owning such an account.
Opponents of using variable annuities inside of an IRA argue that there is no sense in using a tax-deferred investment inside of a tax-deferred account.
Proponents understand it is the IRA wrapper and not the VA that provides the tax deferral in this instance, but point to the remaining benefits of a guaranteed lifetime income and guaranteed death benefit as the reasons why a variable annuity is appropriate for use inside the IRA.
Therefore, the only remaining argument against using variable annuities inside of an IRA would be the cost differential between owning a mutual fund and its benefits vs. owning the VA and its benefits.
As outlined above, from purely an investment perspective, the benefits of a mutual fund and a subaccount are identical. With respect to the guaranteed income option on deferred annuities, utilization levels suggest that consumers have not yet come to appreciate this benefit. So, for the sake of this analysis, I will totally discount the value this benefit may provide to the client.
That leaves the guaranteed death benefit. At its most basic level, the death benefit of a VA guarantees that upon the death of the contract owner the beneficiary will never receive less than the original investment, less withdrawals, irrespective of the contract value at the time of the owners death.
