By Chad M. Kohler, Esq.
"A guaranteed income for life" sounds like a pretty good proposition to most investors.
When I was a stockbroker, I heard countless sales pitches from variable annuity wholesalers who would come into my branch office and tout promises of "guaranteed lifetime income" as the reason why a variable annuity should be part of practically every investor's portfolio.
These promises prove enticing for many investors. At the end of 2013, the total amount U.S. investors had placed in variable annuities was an astounding $1.8 trillion.
Smooth sales pitches aside, variable annuity contracts are often riddled with opaque terms and conditions, high annual fees, hefty surrender charges, and illusory tax benefits. Many investors find out too late that that they would have been much better served if their financial advisor had steered them toward other, more transparent, lower-cost investment alternatives.
Some investors are fighting back. Data from the Financial Industry Regulatory Authority (FINRA) shows a substantial spike in customer complaints relating to variable annuities, according to The Wall Street Journal. FINRA regulates brokerage firms and oversees the mandatory arbitration process through which most customer disputes are decided. The cases at our investment fraud law firm reflect this increase in claims relating to variable annuities.
In my experience, the typical customer purchasing a variable annuity really has no idea what they're actually buying. Sadly, the broker selling the variable annuity often doesn't understand the product much better.
The Securities & Exchange Commission (SEC) recently issued an Investor Bulletin, "Variable Annuities – An Introduction." It serves as a useful primer for investors who are considering buying a variable annuity.
Here are some basic facts about variable annuities that every investor needs to consider.
If your financial advisor is pitching a variable annuity, there's a good chance you've been given a glossy brochure with pictures of happy-faced retirees enjoying their golden years. The brochure may look nice, but it probably provides only a cursory explanation of the variable annuity that is being sold.
With clever marketing, it's easy to be lulled into thinking that a variable annuity provides a safe, simple solution for your retirement income needs. Don't be fooled: variable annuities are incredibly complicated investment products.
At its most basic level, a variable annuity is a contract between an investor and an insurance company in which the insurance company agrees to make periodic payments to the investor. The payments may begin right away (an immediate annuity) or at some later time (a deferred annuity). What makes the annuity variable is that the value of the annuity (including future periodic payments) will vary depending upon how investments inside the annuity perform. These investments are typically mutual funds that are tied to stocks, bonds, and cash equivalents, or some combination of the three.
By far the most confusing part for most investors (and most brokers, if they're being honest) is grappling with the intricacies of various riders that promise guaranteed "living benefits" with minimum "roll ups" and periodic "step ups." There are a lot of moving parts to these contracts, and they "continue to get more complex," as Richard Ketchum, FINRA Chairman and CEO, recently told The Wall Street Journal.
Investors are often caught off guard by what is buried in the fine print. According to Money Magazine, many investors have been surprised recently to learn about contract terms allowing the insurance company to hike fees and restrict investment options.
The bottom line: before you buy a variable annuity, make sure you understand how it works. The best way to do this is to carefully read the variable annuity prospectus, which describes the annuity's features in detail. Don't be afraid to ask your financial advisor questions, and if you're in doubt, get a second opinion.
There's no such thing as a free lunch, and the bells and whistles that are part of most variable annuity contracts come with a hefty price. When you start adding it all up, the expenses can easily bite off 3% or more of your account value per year. This means you need to achieve an annual return of 3% just to break even. Put another way, if the investments inside your variable annuity grow by 5% annually, then the return that your annuity is actually credited after expenses is a meager 2%.
I've talked to many investors who can't understand why their variable annuities have remained stagnant in recent years even as the stock market has done well. More often than not, the culprit is the hefty expenses the investor is paying. In many cases the investor finds that they would have been better off sticking with a traditional investment account holding a diversified mix of equities and fixed income.
In addition to annual expenses, investors also need to be aware of surrender penalties, which apply to withdrawals made within a specified time period after the annuity is purchased. The penalty period is usually six to eight years, but some contracts go out 10 years or more. The penalty assessed is a percentage of the amount withdrawn and generally declines over time. For example, a 7% surrender penalty might apply to withdrawals made in the first contract year, 6% in the second year, and so on. For investors who tie up all of their assets in a variable annuity and find themselves cash-strapped only a few years into the contract, surrender penalties can take a heavy toll.
An often hyped benefit of a variable annuity is tax deferral. Tax deferral means that the investments inside the annuity grow tax free and taxes on gains are paid only as money is withdrawn. But other investment vehicles (most notably IRAs and 401(k) plans) already offer tax-deferred growth. For most investors who are not yet retired, it makes no sense at all to invest in a variable annuity unless you are already maxing out the allowable contributions to all of your retirement accounts.
Even then, the supposed tax-deferral benefits of a variable annuity might be misleading. This is because investment gains in a variable annuity are taxed at your highest marginal income tax rate. By contrast, investment gains in a traditional brokerage account are taxed at the lower capital gains tax rate. According to a study cited by Forbes, even individuals in a 36% marginal tax bracket "will never come out ahead by investing in a variable annuitydue to the prolonged drag of fees and tax issues."
Moreover, for retirees who are considering investing in a variable annuity in their IRAs or other qualified retirement plans, it is important to understand that the variable annuity will not provide any additional tax benefits. For these investors, a variable annuity only makes sense if the annuity's other benefits, such as lifetime income payments, are worth the cost. As noted above, for many investors, the costs outweigh the benefits.
About Meyer Wilson
The team of investment fraud attorneys at Meyer Wilson has successfully represented nearly 1,000 individual investors from across the country who have suffered financial harm at the hands of stockbrokers, brokerage firms and insurance companies. We have won verdicts, arbitration awards and settlements of hundreds of millions of dollars for our clients. If you believe you have a case involving investment misconduct our firm can help. Meyer Wilson represents clients nationwide from offices in Ohio and California.