Annuities are one of those securities that elicit strong opinions. Love them or despise them, in certain situations they can be an important component of a client’s portfolio. Whatever your belief, the efficacy of annuities is not the subject of this post. Instead, we will focus on a little-known aspect of fee-only variable annuities and reveal how advisory fees can actually increase a client’s tax burden and expose them to an IRS penalty.
Annuities: The Basics
An annuity is a product of an insurance company and may be immediate, deferred, fixed or variable. Annuities also contain risk. For example, in the event of an insurance company failure, because assets in a fixed annuity are part of the company’s general account, they are subject to the claims of creditors. Conversely, assets in a variable annuity are held in a separate account and do not contain this risk.
For many years, variable annuities tended to have a high fee structure. This helped provide contractual guarantees for investors and a generous sales commission for the broker or advisor. The commissions were often so attractive that it enticed brokers to sell an annuity even when it was not in the best interest of the client.
This, plus the growth of the registered investment advisor channel, has helped to bring major changes in the annuity landscape. One of the most significant changes is the emergence of the fee-only annuity, which tends to have much lower internal fees and, as the name implies, does not pay a commission. These annuities have become a popular alternative for clients of some RIAs.