As a finance professor, I meet and work with well-educated investors every day. When discussing their investments, I often find that these investors not only understand variable annuities, but own them in their own investment portfolios.
When asked why they invested in variable annuities, they usually give several reasons, including the following:
1. Commission-free Investing
Unlike most mutual fund and stock investments, when variable annuities are purchased, no up-front, out-of-pocket commission is charged to the investor. A declining contingent deferred sales charge is imposed if the variable annuity is not held for an agreed holding period that averages six years. Long-term investors are rarely concerned about contingent deferred sales charges (CDSC) because they hold their variable annuities for the agreed holding period, thus avoiding these charges. Purchasers of variable annuities, depending on their needs, can select variable annuities with holding periods ranging from zero to 10 years. Typical mutual funds and stocks require investors to pay up-front, out-of-pocket commissions. Knowledgeable long-term investors realize that investing without having to incur commissions will increase their investment gains over time.
2. Low Annual Cost of Investing
The annual cost of owning the average, actively managed equity based variable annuity, whether in a taxable account or retirement account (i.e., IRA, 401(k), etc.), is less than the annual cost of owning the average, actively managed equity mutual fund. An actively traded stock portfolio can generate commissions and taxes that can exceed the annual cost of owning the typical equity-based variable annuity.
3. Tax-Deferred Investing
Variable annuities grow tax-deferred. This not only simplifies owning variable annuities but eliminates the payment of income taxes that some investments, like mutual funds, generate annually regardless of whether the funds increase or decrease in value. Successful and knowledgeable investors understand the importance of tax-deferral. John D. Rockefeller once said, “The surest way to accumulate wealth is to make sure you never pay taxes on income you don’t use.” Because variable annuities grow tax-deferred, income taxes are not paid until withdrawals are made from these annuities. Tax conscious investors realize that by avoiding taxes today, their variable annuity will grow to a larger amount than taxable investments and may be subject to lower income taxes after retirement. A LIMRA study conducted in 2003 found that 67 percent of affluent households cited income tax considerations as the leading reason for contacting financial professionals.
4. No-Cost/Tax-Free Trading
Variable annuity owners may trade among the different fund families in their variable annuity without paying commissions. In addition, these trades do not result in taxable transactions. Changing investments among different mutual fund companies or buying and selling stocks may involve either an additional commission or the triggering of an income tax liability or both.
5. No-Cost Asset Rebalancing
Nearly every variable annuity issuer today will, without cost, automatically rebalance a variable annuity owner’s investments on a periodic basis. Even if automatic rebalancing is not provided, variable annuity owners are free to rebalance their investments without cost and without triggering an income tax liability. Cost-free rebalancing is not generally available with mutual funds and stock accounts. Where such rebalancing is accomplished by a mutual fund or stock owner, such changes often result in the imposition of additional commissions or taxes or both.
6. Tax-Efficient Withdrawals at Retirement
Most mutual funds involuntarily force income on their fund owners each year. This creates an income tax liability which in turn produces a nest egg that will be smaller than if variable annuities were owned. The reason for this is that variable annuities grow on a tax-deferred basis. Many people assume that the income tax liability for retirees who own variable annuities will be greater than that for those who own mutual funds. This rarely proves true. Few people are aware of the fact that a retired couple who can keep their gross income at or below $85,000 a year and who have average deductions and personal exemptions will pay federal income taxes on their taxable income at 15 percent regardless of how much of this income comes from variable annuity withdrawals (including all of it!). For such couples, seeking to obtain a temporary 15 percent long-term capital gains rate would not seem to be all that critical.
7. Death Benefit
Variable annuities, unlike any other investment, provide a death benefit that will refund all net investments made by a variable annuity owner to their survivors when the annuity owner dies if the variable annuity account value reflects a loss. Many variable annuities, for a small fee, will provide a death benefit that increases at a stated rate (e.g., 5 percent to 7 percent) each year. By exchanging variable annuities at the end of a surrender period, a new death benefit equal to the annuity’s current value can be obtained without cost. Mutual fund and stock investments offer no such protection to an investor’s family.
8. Principal Protection and Guaranteed Lifetime Income
A recent Barron’s lead article pointed out that wealthy clients were, “…more interested in preserving their wealth than making huge gains.” This may be one reason for the increased popularity of variable annuities among sophisticated investors. Today, 85 percent of variable annuity issuers provide one or more living benefit riders with their annuities. These riders are designed to protect long-term investors from losing their principal while allowing them to participate in the potential upward movement of the stock market. In addition, these riders may also guarantee a stream of income for the life for the annuity owner. This stream of income can increase with a rising stock market but cannot decrease in a declining stock market. Most of these modern lifetime income riders do not require the variable annuity owner to annuitize their annuity to obtain these benefits. Access to the annuity remains with the owner. These new annuities also provide a substantial death benefit for the surviving spouse. Neither mutual funds nor stocks provide similar benefits. The total annual cost of owning a variable annuity that provides income for life, a death benefit and principal protection or guaranteed income for life is about the same as the annual cost of owning an average, actively managed equity mutual fund that fully exposes the investor to all losses resulting from a declining stock market.
9. Better Performance
The annual cost of owning the typical mutual fund can be as much as 2 percent more than the annual cost of owning a similar variable annuity. For this reason, it is not surprising that the annual performance of variable annuities is better than that of mutual funds and stocks. For example, in 2004 the value of all variable annuity accounts increased at a rate of 12 percent. This return outperformed the Dow (3.2 percent), NASDAQ (8.6 percent) and the S&P; 500 (10.9 percent). In 2005 the value of all variable annuity accounts increased at a rate of 5.5 percent. This return outperformed the Dow (1.7 percent), NASDAQ (2.1 percent) and the S&P; 500 (4.8 percent).
10. Tax-Efficient Wealth Transfer at Death
Variable annuity investors have learned from their tax advisors that variable annuities can be transferred at death in a very tax-efficient manner. As a tax attorney, I often point out to my clients who own variable annuities that with some very basic tax planning, variable annuities can avoid both estate taxes as well as any income taxes that might be owned by the beneficiaries who inherit them. Such a result often saves significantly more in estate and income taxes than can be saved by relying on the step-up in basis so often taunted as a benefit by those who sell stocks and mutual funds.
The bottom line
What I have found in dealing with both financial advisors and investors is that advisors understand the important role that variable annuities can play in helping their clients reach their financial goals, and they do an excellent job of explaining the many benefits that variable annuities can provide to their clients. As long as there are advisors who strive to help their clients reach their financial goals and as long as investors take the time to examine the unique features and benefits variable annuities offer, the sale of variable annuities will continue to set new records.