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.