Sales of traditional variable annuities have taken a substantial hit in recent years, but a subset of the product class continues to attract clients who are set on increasing tax-deferred savings potential in pre-retirement years.
The investment-only variable annuity (IOVA) is a type of variable annuity that is generally attractive because of its lower price tag and unique investment opportunities—paired with the traditional tax-deferral offered by a nonqualified annuity product. However, unlike the guaranteed income appeal of the traditional annuity, the primary appeal of the IOVA lies in the magnification of income tax deferral through the unique investment diversification opportunities offered by the product.
The Investment-Only Variable Annuity
IOVAs are a subset of variable annuity that are, as the name suggests, focused on the investment potential of a tax-deferred annuity product. Importantly, these products offer the same tax-deferral benefits as a traditional annuity product, so that the income earned on investments is not taxed until the accumulated funds are withdrawn.
IOVAs are also attractive because the fees that a client must pay to maintain an IOVA are much less than those applicable to other types of annuities (some products offer a flat fee that is as low as $20 per month, and many products have no surrender charges). Studies have shown that this allows for more robust investment growth, as the high fees that are associated with guaranteed variable annuities (which can exceed 2 or 3 percent each year) can erode returns and increase the risk of wealth depletion in the long run.
IOVAs offer a wide range of investment options, including both conventional investment portfolios and some that are not widely available to average clients—often, “alternative” investments, such as real estate, commodities and hedge fund options. The use of such a wide range of investment options theoretically allows an IOVA to offer downside protection through the use of hedging strategies and diversification.
Further, the product allows clients to invest in alternative investment classes without paying ordinary income taxes or short-term capital gain taxes in the short term, allowing the investment to grow without reduction for taxes (potentially for years). Because of the low fees associated with these products, the tax-deferred growth potential is magnified.
IOVA Candidates and Potential Pitfalls
One of the primary downsides of investing in an IOVA is that, even though there are often no or low surrender charges, the IRS imposes a 10 percent penalty on funds withdrawn before the client reaches age 59 ½. In this respect, the funds cannot be accessed by the client for a period of time and may not be appropriate for clients with limited funds to invest.
The client should be able to max out his or her contributions to retirement accounts before committing to an IOVA, where the primary appeal is tax-deferred investment growth over a long period of time. Unlike IRAs or 401(k)s, there are no minimum distribution requirements that begin to apply once the client reaches a certain age, so that the long-term growth potential of the IOVA can be maximized.
Clients who wish to purchase an annuity with a death benefit will have to pay more for the IOVA, which traditionally does not offer a death benefit, although many firms now provide for optional death benefits or return of premium riders.
While traditional variable annuities may continue to decline in a post-recession, post-fiduciary rule world, the more simple IOVA may continue to appeal to clients looking to expand their tax-deferred savings options.