A Variable Annuity Inside An IRA? Educate Clients, Let Them Choose

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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.

More popular variations of the basic death benefit include a highest anniversary value (step-up) and an annual guaranteed compounding rate death benefit.

In general, opponents of VAs have scoffed at these benefits as a “thin veneer” of insurance protection. However, todays market environment has proven that variable annuities can provide economic value.

In addition to any monetary value that can be provided by a death benefit, they can also provide an emotional support element in times of volatile equity markets that allow clients to “stay the course” since they can be certain that their loved ones have a defined level of protection against market downturns.

If you agree that mutual funds are an appropriate investment to use in an IRA and also agree that the investment benefits of mutual funds and subaccounts are the same, then the question is not whether a VA makes sense inside of an IRA; rather, the question becomes: ‘Is my client willing to pay potentially higher internal product costs to own a professionally managed, diversified, marketable investment vehicle with a death benefit?’

Other issues surrounding VAs that are often the subject of debate, such as turning capital gains into ordinary income, become irrelevant since the IRA wrapper will dictate the answer to that question.

A variety of pricing mechanisms is available for mutual funds sold through paid financial advisors, including front-end load, back-end load, level load and even no load where the mutual funds are used as an underlying investment in an asset management account that levies the client an annual fee.

These pricing arrangements are also available on VAs, and while the intended holding period for a mutual fund should dictate which pricing option is going to be the most cost-effective for the client, the similarities between the back-end load or “B” share mutual fund and the abundance of VAs in the marketplace today make them a good point of comparison.

Similarly, if one were to do a comparison of the cost of a front-end load or “A” share mutual fund, which would generally carry lower internal fees than the “B” share counterpart, that comparison should be made against a variable annuity with a comparable pricing structure.

This type of cost analysis allows for an “apples to apples” comparison. With respect to pricing, the bottom line is that actuaries can create a model for variable annuities to match any mutual fund pricing alternative with the resulting trade-off being passed on to the consumer in the form of higher or lower internal distribution fees within the VA.

Once youve determined that a professionally managed, well-diversified investment portfolio is a suitable investment choice for your clients IRA, be sure to point out the differences and similarities between mutual funds and variable annuities.

Communicate the fact that it is the IRA wrapper that provides the tax benefits for the account and that the variable annuity will provide no extra tax advantages. Go on to explain the added value of the VA death benefit and the cost difference that will be incurred to own it.

Mutual fund industry data suggests that the average “B” share fund expense is 2.09%, while VARDS indicates that the average weighted variable annuity contract expense is 2.16%. If upon comparison your pricing scenario produces a similar 7-basis-point cost differential, the annual economic cost of adding the death benefit to the investment benefits of professional management and diversification is $70 annually on a $100,000 investment.

Going through this product comparison process with your clients will allow them to understand the features and benefits associated with both investment product types. It will also arm them with the cost information necessary to make an educated decision on whether a death benefit makes sense for them. Given todays volatile equity markets, its the least we can do for our clients.

, CMFC, is national sales manager for First Union Insurance Group, Charlotte, N.C. He may be reached via e-mail at charles.petrizzo2@ firstunion.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 10, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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