Variable Annuities: Guaranteed Income, With a Catch

Annuity sales are exploding as baby boomers shift their focus from saving for retirement to creating an income stream that will last a lifetime. Some annuities are simple and straightforward. For example, with an immediate annuity, you pay a lump sum to an insurance company, which pays a fixed amount every year for life, starting -- that's right -- immediately. Deferred-income annuities (also known as longevity insurance) are a close cousin: You pay a lump sum in exchange for a higher payout that starts several years in the future.

But variable annuities and fixed-index annuities introduce higher fees and complicated formulas that many investors don't understand. And some salespeople take advantage of the complexity, focusing on the benefits while glossing over the fees, surrender charges and complicated rules that can limit access to the guarantees.

Last fall, Sen. Elizabeth Warren (D-Mass.) released an investigation of the annuities business that found that 13 of the 15 insurers her office queried offered salespeople perks and kickbacks -- including expensive vacations and other prizes -- to push their products. Such incentives create conflicts of interest, Warren warns. Plus, sellers earn commissions that can be 7% or more of your investment.

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Many states have already enacted rules designed to stop some of the most egregious practices. And a proposed Department of Labor rule is likely to tighten the screws. It would likely set a fiduciary standard for anyone who gives financial advice about IRA investments. (More than 60% of variable annuity sales in 2015 were in retirement plans.) That means advisers would be legally bound to act in your best interest, even at the cost of their own, when making recommendations to you.

How variable annuities work

A variable annuity is part investment, part insurance. You put your money in mutual-fund-like accounts, and gains are tax-deferred until you withdraw the money. Withdrawals are taxed as ordinary income rather than at lower capital-gains tax rates, just like payouts from traditional IRAs.

As more people invest in variable annuities inside their IRAs, the appeal of tax deferral clearly isn't the incentive. Rather, it's the income guarantees that draw IRA investors. The cost of these guarantees varies by insurer but typically ranges from 1% to 1.5% of the amount you invest.

How the guarantees work varies by insurer, too, but usually the insurer promises that you can withdraw a certain amount of money every year for the rest of your life, even if the investments you choose lose value or you run out of money. The calculations are complex. The balance that your guarantee is based on (called your benefit base) may grow by 4% or 5% per year or by the highest point your investments have reached during the year (sometimes on the anniversary date of your investment), whichever is higher. The guaranteed step-up means that the value of the benefit base can grow more than the value of your underlying investment.

Say you're 60 years old and your actual investments are worth $350,000 but your benefit base has grown to $500,000 over a number of years. If you withdraw 4% of the benefit base every year, which is $20,000 per year, it will take you 17.5 years (to age 77.5) to withdraw more than $350,000. If you live longer than that, the rest of the payouts will come from the guarantee.

How can you lose? "One of the challenges is that there are an awful lot of guarantees that come with big asterisks that are never fully explained," says Tim Maurer, a certified financial planner in Charleston, S.C., and author of Simple Money. "You have principal protection or high-water-mark protection, but the only way you can take advantage of that is if it's paid out over the course of many years, and that, to me, is not a real level of assurance." Not only that, but you can't access your benefit base as a lump sum; if you cash out your annuity, you'll get only your actual investment value.

Another knock on some variable annuities is the high fees. Basic annuity fees (called mortality and expense fees) can run 1.2% or more per year. You could also pay more than 1% in investment fees for the underlying funds. If you decide to cash out the annuity, you may pay a surrender charge, which generally starts at 7% to 10% and gradually decreases over the first seven to 10 years you own the annuity.

There are variable annuities with lower fees. Vanguard sells one directly to investors that costs 0.75% or less per year for the annuity and investments, plus an extra 1.20% if you add an income guarantee. The guarantee locks in the value of the investments on the policy's anniversary each year and bumps up the benefit base if the value of your investments on that date has increased. You can take 4% of the benefit base each year for the rest of your life if you start taking withdrawals between ages 59 and 64, or 5% if withdrawals start between ages 65 and 79. Similar low-expense products from Ameritas, Jefferson National and TD Ameritrade are sold through advisers who charge separate fees for their services.

Is one right for you?

Reasonable-fee variable annuities with guarantees can be appropriate for some people in their fifties or sixties who fear retiring in a down market and running out of money later in life. Matt Sadowsky, director of retirement and annuities for TD Ameritrade, says you generally should consider investing no more than 30% of your liquid net worth in an annuity -- total assets minus the value of your personal residence. "Annuities should provide a floor of guaranteed income to supplement Social Security and pensions to meet the expenses you need to cover for the rest of your life," he says.

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Before buying a variable annuity, check its prospectus for information about fees and investment choices, and make sure you understand exactly how the guarantee works. "Ask questions and compare alternatives," says Gerri Walsh, senior vice president of investor education for Finra, which has issued investor alerts about annuity sales. "What is your goal in seeking out this annuity? Are you considering it only because somebody recommended it to you? Is this the most efficient way to achieve your goals?" She recommends getting a second opinion from someone who doesn't have a financial stake in your decision.

Be careful about adding costly perks. For example, you may want an income guarantee but not a feature that boosts the death benefit. “Be leery of agents who want to add all kinds of riders. It takes more money out of your account and puts more money into their pockets,” says Barry Lanier, chief of the bureau of investigations for the Florida Department of Financial Services.

Strategies for getting out

If you discover that you didn't really need an annuity or that yours is charging particularly high fees, getting out can be complicated.

If you change your mind right away (within about a month in most states), you may be able to get your money back. (For your state's rules and protections, see the links to state insurance departments at www.naic.org.)

After a free-look period, you'll have to pay income taxes on any gains, and you may have to pay a surrender charge. If you decide to switch to a lower-cost annuity, you can avoid the tax bill by making a tax-free transfer (called a 1035 exchange). You won't avoid surrender charges, but you will continue to defer the tax bill until you withdraw the money from the new annuity. (Vanguard offers a tool that calculates how much money you could save by switching to its annuity; see www.vanguard.com/annuity and click on "transfer an annuity.")

Before you switch to another annuity company or take any withdrawals, be sure you aren't giving up valuable guarantees. If the investments are worth less than the guaranteed value, you'll lose the benefit for which you may have been paying thousands of dollars each year. Plus, the guarantees on annuities sold before 2010 tend to be more generous than those available on new annuities, says Mark Cortazzo, a CFP in Parsippany, N.J. His Annuity Review service (www.annuityreview.com) charges $299 to analyze up to two annuities you're considering or already have.

Cortazzo recently worked with David Palay, 51, who owns a medical-device sales and marketing company in Milwaukee. Palay bought an annuity in 2003 with a lifetime income guarantee. He was happy with it, especially after the stock market downturn in 2008, but began to question whether it was the right choice after he started working with a new financial adviser, who recommended that he get out of the annuity and pay him to manage the money instead.

"I was looking for a third party without any skin in the game who could give advice about whether the annuity was appropriate," says Palay. Cortazzo found that the annuity's benefit base was worth 30% more than the actual account value and that Palay could lose tens of thousands of dollars in income benefits if he cashed it in. Also, the guarantee was less expensive and more generous than guarantees on new annuities.

"Ultimately, I decided to keep the annuity but stop adding new money," says Palay, who figured he had already locked in enough guaranteed income from the annuity to cover his expenses in retirement.

Florida's annuity reforms

In January 2007, Kiplinger's featured an 85-year-old Florida woman who was sold an annuity with surrender charges that lasted until she was 101 years old, including a 25% surrender charge for the first five years. In 2009, the Florida Department of Financial Services opened 431 annuity investigations based on consumer complaints. Some reported surrender charges of up to 25% of the account value for withdrawals in the first 15 to 20 years, says Barry Lanier, chief of the bureau of investigations for the Florida Department of Financial Services. "We've collected millions of dollars in restitution for consumers, much of it in the area of annuities," says Lanier, who helped the Florida woman we wrote about.

From 2008 to 2010, the Florida legislature passed a series of laws that established suitability requirements for annuity sales plus capped surrender periods at 10 years and surrender charges at 10% for annuity sales to buyers who are 65 and older. Annuity complaints have dropped significantly since then. Most states have enacted similar laws for annuity sales over the past few years.

Hidden fees, so-so results

Fixed-index annuities are even tougher to decipher than variable annuities -- but sales are taking off. Formerly called equity-index annuities, these products promise to accumulate interest based on the performance of certain indexes, with a minimum guarantee (such as 90% of your initial investment plus 1% to 3% in annual interest). You won't lose money in these products, but if the market does well, you'll earn much less than you would have by investing in a fund that replicates the index.

The fees for fixed-index annuities are embedded in the interest rate calculations rather than disclosed in a prospectus. Those calculations vary by annuity. Some offer a percentage of the performance of the index (called the participation rate), such as 80% of the growth of the S&P 500, not counting dividends. Or they may subtract a certain amount from the annual growth of the index -- perhaps 2.25 percentage points. Or they may cap the growth of the index at, say, 8%. They generally do not include dividends in their calculations. Some index annuities impose several limitations, and they may change after you purchase the annuity.

Note that a securities license is required to sell variable annuities but usually not to sell fixed-index annuities, so a salesperson may not be able to offer or compare both options.