Abstract:
Today, with the stock market at levels not seen in 12 years, many equity-oriented variable annuities have passed their surrender penalty periods and have no earnings to be taxed. Now may be the time to get out from under those fees and look for better options.
Not long ago I spent a number of hours helping a client in her sixties review her holdings in order to develop a strategy for generating income and assets to fund her retirement. One of her holdings was a variable annuity from an insurance company called Allmerica, the Allmerica Advantage. I studied this annuity in detail, and for the life of me I couldn't see the "advantage" for her (sorry for the bad joke).
This annuity had been purchased by her husband many years before as a savings vehicle. The logic seemed straight forward. The owner earns tax free returns on the appreciation of a basket of mutual funds chosen from a predetermined group of options. Also, there is a death benefit feature that would pay out to his beneficiaries at least as much as the owner put into the annuity . In exchange for this death benefit, the owner pays fees and accepts a "surrender period" - in this instance 9 years, during which he will be penalized for withdrawing his assets.
In this situation the annuity transferred to the wife upon the death of her husband. It had passed the surrender period. Further, due to the poor performance of the stock market during the past 12 years, it had no earnings since its value was less than the amount invested in the various mutual funds. Therefore the cost to redeem was zero from a tax perspective and zero from a surrender charge perspective. The one catch was that it was below its death benefit.
This particular annuity had a series of fees that were as follows:
Mortality and Expense: 1.25%
Administrative Charge: 0.20%
Fund Mgmt Expenses: 1.01%
Total Expenses 2.46%
Recognizing that there was a death benefit, but given the above fee structure, and the recognition that her goals were retirement income-oriented, my advice was the following:
If your primary concern is not the size of the inheritance you are going to leave, but how you are going to enjoy the next twenty or thirty years, cash it in and have it managed by a fiduciary (Registered Investment Advisor) who will charge you much lower fees and give you advice in the process.
Also, I see shedding the high fees of the annuity as a "life benefit." A savings of 1-1.25% per year for many people is enough to pay for a few nice weekend getaways or an emergency car repair if needed.
Aren't we missing the option to annuitize? Yes, a single premium annuity is an attracitve option to some, and in her case. If we were to visit the Website of Bekshire Hathaway Direct, we would learn that for her life she could lock in a yield of 3.65% and that it would be tax advantaged for the first 18.5 years because during that period the IRS will consider 75.7% of each monthly payment a return of principal.
A key catch is inflation.
Assuming 3% inflation - one's purchasing power will go down by 50% over the next 12 years, so the $1639 monthly payment will only seem like $819.50 in today's dollars when this annuitant is 79 years old. Further, once the money is in the annuity, the annuitant must prove financial hardship to access the principal, and if she passes away in two years, the insurance company "wins the bet."
An alternative would be to purchase a U.S. Treasury 20 year inflation protected security. According to Bloomberg, the 20 Year TIP currently offers a real yield of 2.4%. Combine that with a 3% inflation rate and the holder receives 5.4% for holding the bond. Additionally, as a Treasury bond it offers the backing of the U.S. government, combined with this built-in hedge against inflation. Not bad right! Further, should one want to be more aggressive and maintain some investments in the stock market, a portfolio of blue chip stocks would offer a growing (one hopes) 2.5-3.0% dividend yield. If these dividends grow at a 3% rate of inflation, then the payout will feel like 3.75 - 4.5% in 12 years time.
Amidst the market turmoil, this is one opportunity to look at a widely held instrument (the variable annuity) in a new light.
Posts
