Anyone researching variable annuities (hereafter referred to as VAs) will quickly come across volumes of negative information and press. Similar to whole life insurance and reverse mortgages, VAs are highly controversial products that have always been the subject of great debate. In fact, there are many who passionately proclaim that, “nobody should ever own one.”
I believe it is extremely unprofessional for anyone to state that any financial product is always bad. If VAs were really a bad investment for every person in every situation, then people would not continue to buy them, and the VA industry would not exist today. However, the VA industry is robust, which means people choose them because there is a perceived value.
Debunking VA myths
Over the past decade, the amount of money in VAs has grown to levels greater than any other period in history. This should not necessarily be viewed as good news. VAs are complicated and sophisticated products containing lots of moving parts. Given the growing number of VA companies, contracts and riders, these products are becoming increasingly complex.
This complexity opens up many challenges for investors. For example, VAs can be recommended and sold by primarily using “good soundbites” rather than spending significant time to review and analyze the details. In addition, because these products are so complex, they can be misunderstood and, in some cases, inappropriately sold.
In an effort to determine which prospects are a good fit, here, we will attempt to debunk the most popular myths about VAs and hopefully provide some clarity.
Myth No. 1: VAs have large surrender penalties.
It would be far too time consuming to list all of the various surrender penalties within each of the VA companies and contracts. For the sake of brevity, below are two examples of common surrender period options and penalties.
VA option 1: 7-year surrender period
Examples of 7-year surrender penalties include:
- 7% (Year 1), 7% (Year 2), 6% (Year 3), 6% (Year 4), 5% (Year 5), 4% (Year 6), 3% (Year 7), 0% (Year 8 and beyond)
- This 7-year option usually has lower annual fees
VA Option 2: 4-year surrender period
Examples of 4-year surrender penalties are as follows:
- 7% (Year 1), 7% (Year 2), 6% (Year 3), 6% (Year 4), 0% (Year 5 and beyond)
- This 4-year option usually has higher annual fees
Myth No. 2: VAs “lock up” your money.
Many people believe that if you buy a VA, your money becomes inaccessible. To some extent, I can understand this argument. However, I believe it is important to address this concern in-depth. Let’s look at five key points within this larger point.
The VA suitability test
These are the two most important questions for the “annuity suitability test:”
- At the time you plan to start taking income, will your best and worst-case income be enough (preferably more than enough) to satisfy your needs and objectives?
- Do you have any intention, plan or need to access large sums of your money in a short period of time? (This does not include health, Long-Term Care, or nursing home expenses).
10 percent of your money is penalty-free
Every VA contract includes a provision that allows you to access up to 10 percent of your original investment every calendar year without penalty. This free-access provision means you can withdraw up to 10 percent of your money every year, at any time, for any purpose.
What if you need to access more than 10 percent?
Most VA contracts have surrender penalties if you need to access more than 10 percent per calendar year in the early years of your contract. Because of this, a VA is not suitable for people who may need to withdrawal large amounts of money in a short period of time.
Another important consideration is that, if you need to withdraw more than 10 percent per year (for reasons other than health, Long-Term Care, or nursing home expenses), this withdrawal rate is unsustainable. In other words, no matter what vehicle you choose, taking out more than 10 percent per year creates an extremely high probability you will run out of money in a short period of time.
A case study
In an effort to fully debunk the myth that VAs lock up your money, let’s review a hypothetical example:
You decide to invest $1,000,000 into a VA. Due to some unexpected and unplanned reasons (not related to health, Long-Term Care, or nursing home expenses), you need to access $200,000 in year four, at which time, your surrender penalty is 5 percent.
As previously noted, you can access 10 percent of your money penalty-free, which in this case is $100,000. Therefore, the 5 percent surrender penalty only applies to the additional $100,000. For this example, we’re looking at a $5,000 fee. So, rather than being able to access 100 percent of your money penalty-free, you can access 98 percent ($195,000 versus $200,000).
For those who believe VAs tie up your money, hopefully this helps to explain the reality of how this vehicle really operates. It is difficult to argue that a 2 percent penalty substantiates the myth that VAs “lock up” your money.
The truth about fees and liquidity
If your client correctly answers the annuity suitability questions we posed earlier, then VAs usually offer access to more money than most people should need in any given year, without any penalty.
Regardless of what investment product you choose, if you know in advance that you need to access a large portion of your money in a short period of time, you can expect there will be higher fees involved.
Myth No. 3: Financial companies have only your best interest at heart.
It is important to understand the truth about banks, insurance carriers and investment companies. In order for these financial companies to keep their lights on, pay their expenses and market, advertise and grow, they must have a sustainable revenue model that produces regular and recurring income. If you look at the business models of every financial company, there are four foundational and fundamental principles consistent across the board:
- They all operate on a for-profit basis
- They all sell something intangible
- They all collect fees, costs and/or expenses
- They all need your money to make money
No financial company can exist without your money.
Here are the three primary objectives for every financial company:
- Gather as much of your money as possible
- Hold on to your money for as long as possible
- Give you back as little of your money as possible
To further debunk the myth about VAs and higher fees, here is a simple example.
If you want to purchase mutual funds, here are the three most common options:
- Buying “A” shares: This option charges a 5–6 percent up-front sales charge in exchange for lower fund expenses.
- Buying “C” shares: This option charges a 0% up-front sales charge in exchange for higher fund expenses.
- Paying a fixed annual fee: This option charges a fixed annual fee in exchange for professional money management and the lowest fund expenses.
As you can clearly see, the first option has higher fees now, and lower fees later. The second option has lower fees now, and higher fees later. And the last option has fees that remain the same every year. However, no matter which mutual fund option you choose, each option is built upon the same chasse: collecting long-term fees, and penalizing you if you try to access your money sooner rather than later.
Whether you invest your money for the short or long-term, every investment has a model designed to capture fees. If any financial company does not gather your money and collect your fees, they cannot exist.
Myth No. 4: Lower fees mean a better investment.
Over the years I have found that far too many investors base their investment decisions on fees. However, fees do not determine your long-term investment success or failure.
To help explain, which of these two investments would you purchase?
- An investment with a 10% annual fee, and a 30 percent annual return
- An investment with a 1% annual fee, and a 5 percent annual return
In the first option, virtually no investors would invest in something with 10 percent annual fees. However, almost every investor would flock to invest in something that grows at 20 percent per year, net of fees.
In the second option, most investors would invest in something with 1 percent annual fees. However, very few investors would aggressively seek an investment that only grows 4 percent per year, net of fees.
Performance versus fees
Rather than focusing on fees, your primary focus should be:
- Who is the person/people/company managing the money?
- What is the long-term investment philosophy?
- What is the long-term performance, in both good and bad years?
Some investment options have high fees, and some are lower. What matters most is your long-term net investment results, which are the result of successfully investing and growing your money over time.
You cannot avoid death, taxes or fees
Whether you choose to invest in a VA, mutual fund, managed account, or professional money manager, you cannot avoid fees.
We’ve all heard the old adage; “Two things you cannot avoid are death and taxes.”
This may be true, but unless you keep all of your money under your mattress, you cannot avoid fees either.
Myth No. 5: High fees make VAs a bad option.
I believe it is extremely important to debunk the myth that VAs are bad investments because of higher fees.
It is true: VAs have higher fees
Considering the large number of VA companies and contracts, it would be impossible to review all of their features and benefits. It would also be impossible to compare the advantages and guarantees inherent in VAs that other investment options do not offer.
However, I believe the following two facts can significantly help debunk the myth that because VAs have higher fees, they are a bad investment option.
Price is only relevant in the absence of value.
In other words, if a VA had the exact same features and benefits of other investment options, nobody would (or should) pay higher fees. So here is the reality:
- There must be a valid reason and added value for VAs to charge higher fees — otherwise nobody would buy them.
- There must a perceived value with VAs that justifies choosing them versus other investment options.
- There must be a reason why VAs have existed, evolved and expanded significantly over the past 100 years.
- High fees do not create poor investment results.
- Long-term investment failure is not the result of high fees, but rather the result of poor money management.
- If your investment results fail miserably and create large losses over time, this means you would have been better off owning a VA, regardless of the higher fees.
Myth No. 6: Higher fees defeat investment results.
When it comes to financial companies and their never-ending quest to gather your money and collect your fees, there is only one way to win the battle and claim victory over this all-important war over fees. This particular strategy is guaranteed to succeed and cannot fail. Best of all, there are only two requirements:
- Avoid large losses
- Have your money available and successfully seize the exponential growth opportunities rarely afforded at bear market bottoms
In other words, the most fundamental principle for investment success is “buying low and selling high.” Seems easy, right? And yet you will find this to be, for the most part, an unattainable victory.
But, if you can accomplish these seemingly simple, yet allusive, tasks, your money will multiply in ways that make fees insignificant and inconsequential.
What are the main objectives of a VA?
By owning a VA, your two basic long-term objectives are:
- Growing your money over time
- Having the option of taking income from the highest possible value
VAs are not a bad, good, or suitable option for everyone. I sincerely hope this article clarifies some of the top VA myths to better identify who really is a good fit.