Saturday, October 14, 2006

Tax-deferred variable annuity retirement account a bad idea

Catching the end of a mutual fund radio show this morning, I heard that there are a good number of people out there (reportedly some 70,000 with a single insurance company that escapes my name) with tax-deferred variable annuity retirement accounts.

Don't open one up. If you've a putatively trusted advisor or insurance agent who suggests you do so, boot him. His conduct is a dereliction of fiduciary duty and will earn him greater revenue through the extra cost but do you no good. If you have opened one, taking the 10% penalty now to pull it out is still likely the right move if the sum isn't enormous.

It makes absolutely no sense to open one, unless you've maxed out all your other tax-deferred options (like 401k, IRA, etc), and even then it's sub-optimal, because if life expectancies have been increased drastically by the time you retire (SENS breakthrough, for example), your monthly stipend will be infintesimal. You'll pay extra fees (in the general range of 1%-4%) on top of the mutual fund fees/commissions that the annuity provider will invest you in (or allow you to choose to invest yourself in). Then, at some point past the age of 59.5, you'll be able to begin collecting an annuity until death based on your life essentials at the time of election. So you'll pay extra to eventually enter into an annuity you would just as well enter by cashing out your 401k or other tax-deferred retirement account (without the extra fees) at the same age and sticking it into an annuity at that point.

(Personal use)


Anonymous said...

I actually considered an annuity at one point, but the thing that most swayed my decision against one was this: they wanted to base the insurance on a percentage of total assets in the account, rather than total contributions (aka principal), which is the only thing that would have been insured. So if you had the kind of annuity that allowed you to choose what the money was invested in (which is the kind I was considering), and you happened to choose an investment (fund) that did well, then you'd pay a percentage of your gains to insure the principal (your total contributions), even though the gains were not insured.

So I said 'forget it'.

Anonymous said...

What if lew rockwell and company get thier way and we go back on the gold standard, and there is deflation? Buying these annuities is a hedge against that.

Analyst said...

Let's not be too hard on annuities. A lot of them are sold for the wrong reasons and to the wrong people at the wrong stage of life. And they do carry higher commissions than straight mutual funds because they are much more complicated to explain. All that being granted, they can be extremely useful and make perfect sense. Herb Stein, the former chairman of the Presidents Council of Economic Advisors was a big owner and advocate of variable annuities. His son Ben Stein, the television personality, author and economist is all so a fan of variable annuities. The essential concept of a modern variable annuity is that it allows you to participate in the growth and earnings of the market through mutual funds while insuring your principal to some degree. There is a commission on the sale of the mutual funds and a fee for the insurance feature.

Variable annuities make sense in times like now for someone in their 50's who has considerable savings and wants to keep it growing while protecting the principal against a serious market downturn. Such a person might want to put half or a third of their savings into a VA.

Most people today use the annuities for the principal protection and the tax-deferred growth features. Not everyone needs these, or needs them enough to justify the fees. Remember that the markets are doing well right now, but there have been five and ten year periods in the last fifty years when the markets were horrific. You don't want the five or ten years before your retirement to be like that and not have some insurance to hedge your position. This is the role the annuity plays. If you are 25 years old and saving for retirement in a tax-advantaged retirement plan then don't buy an annuity--that's not what they are for!

crush41 said...

While I'm no fan of variable annuities, what I was admonishing against was tax-deferred annuities.

I don't see how it can be prudent to pay extra fees to obtain an annuity that doesn't pay out on a regular basis. Why not invest in the same securities/equity/etc that you would via the self-directed annuity using another tax-deferred basis (via traditional IRA, etc) and then after pulling the money out, stick it in a variable annuity?

Analyst said...

I think what we are running into here is the fact that annuities are extremely complex and varied. They can be immediate or future, and fixed or variable. They have an accumulation phase (while you are paying into them) and a distribution phase (while you are drawing out your annuity payment).

All annuities are tax-deferred during the accumulation phase. It wouldn't make sense to purchase an annuity inside a tax deferred plan (IRA, 401k, etc.) primarily for the deferral because the retirement plan already provides deferral. A person could rationally purchase a variable annuity in a retirement plan to obtain insurance against loss of principal; after all, the tax deferral is essentially a freebie. It's clearly true that the extra fees in a variable annuity are a drag on growth, but if someone has significant assets and is concerned with capital preservation then the variable annuity is attractive. What the investor is doing is insuring against the market collapsing at a time when they don't have the remaining years before retirement to recover. This portfolio insurance feature isn't available in any other investment that I am aware of.

During the distribution phase some people feel that it's prudent to insure all or part of their retirement income stream. Using a variable annuity or a fixed annuity they can guarantee an income stream for life. If they choose a fixed annuity they have to worry about inflation reducing the purchasing power of the income over time. A variable annuity can provide a measure of inflation protection but the initial amount of the income stream will be reduced because of the cost of the insurance feature.

So I agree with you to the extent that for many people it wouldn't be prudent to invest in a variable annuity during the accumulation phase--if they had many years until retirement, a small nest egg, or the expectation of another pension (government, military, etc.) that would cover their basic income needs and incorporated inflation protection. Variable annuities are terrific products for some clients; there are a lot of people for whom they make no sense at all.
Best regards..

Anonymous said...

Thanks for very useful information.

anuity /
anuities /
annuities tax

Index Annuity said...

blog is presented in a nice way!!