As you can tell from the title, we don’t much like variable annuities. And we’re not alone. For example, noted financial writer Jane Bryant Quinn once wrote that variable annuities make her so angry that she dreams of blowing them to smithereens. She quoted John Biggs, former chair of TIAA-CREF pension funds, as declaring, “I cannot imagine a personal financial situation where I’d recommend a VA as a good idea.” Mr. Biggs suggested that insurance executives eventually will be marched, handcuffed, through courts for the way they sell variable annuities today.
But, to be fair, we should point out that some people think variable annuities are wonderful products. These people usually are called “stockbrokers” or “insurance agents.” Like insurance agents who sell variable life insurance, brokers and agents earn a great deal of money from selling risky investments to people using deceptive sales practices.
Variable Annuities are the Subject of Incredible Sales Abuse
It’s easy to understand why brokers and insurance agents love variable annuities. These folks earn from 5 percent to 15 percent in hidden commissions for the sale of a variable annuity, making the product a huge cash cow for financial services professionals. Consequently, many sales people will indiscriminately pitch a variable annuity to anyone, regardless of age or need. They often prey on seniors and early retirees, people who generally have no business owning variable annuities. In fact, the NASD (now called FINRA) has brought scores of disciplinary actions alleging improper sales of variable annuities, a huge number of actions that nonetheless represent just the tip of the iceberg. Sales abuses became so prevalent that in September 2007, the SEC approved FINRA Rule 2821 requiring brokers to determine specific suitability criteria when recommending the purchase or exchange (but not the surrender) of deferred variable annuities.
What are Variable Annuities?
In a nutshell, a variable annuity is a long-term investment in mutual funds (called “sub-accounts” in VA lingo), but instead of buying the mutual funds directly, you buy them through a contract issued by a life insurance company. The contract provides a pseudo-insurance wrapper that protects against loss of your initial investment (but only if you die), allows your money to grow on a tax-deferred basis like an IRA or 401k, and gives you the option to “annuitize” your investment, i.e., to irrevocably sign your money over to the insurer in exchange for a guaranteed stream of monthly payments. To the unsuspecting investor, variable annuities can be made to seem very attractive, but many of these investments are ugly on the inside.
Variable Annuities Are Often Horrible Investments
Variable annuities have so many flaws and traps; it’s hard to know where to begin. Here are some of the major ones:
Contingent Deferred Sale Charge (CDSC)
First, most variable annuities have what is called a contingent deferred sale charge, or CDSC. The CDSC is a penalty for early withdrawal of funds and is designed to ensure that you don’t surrender the policy until the insurance company has gotten enough fees out of you to reimburse itself for the huge commission it paid the agent or broker. It usually starts out in the first year at around 6 percent or more of your account value, decreases by about 1 percent per year thereafter and eventually disappears. But if you need to get your hands on your money before the surrender charges end, you can be forced to pay a heavy price. Unscrupulous sales people will sometimes try to get you to switch to a new annuity in midstream just so they can earn a new commission, an abusive practice sometimes called twisting. If you succumb to this tactic, you’ll end up needlessly paying a CDSC and starting a new surrender period on the replacement annuity, thereby tying up your money for an even longer period.
Tax Deferred Growth
The best and most valuable feature of variable annuities is that they provide growth on a tax-deferred basis, meaning you only pay taxes on your profits as you withdraw them. But if the funds you want to invest are already subject to tax-deferral because they are in an IRA, 401k, or other retirement plan, it’s ludicrous to even consider a variable annuity since the primary benefit of the product – i.e., tax deferred growth – isn’t needed. Nevertheless, brokers and insurance agents continue to urge customers to put tax-deferred retirement money into variable annuities, a practice that has been strongly criticized by FINRA, the SEC, and most independent financial planners.
Profits Taxed at Ordinary Income Rates
Another problem with variable annuities concerns the way your profits are taxed upon withdrawal. When you eventually take your profits (assuming you have any), they’ll be taxed at ordinary income rates rather than the lower capital gains rate applicable to profits from long-term direct investments in mutual funds and other investment vehicles. This can cost you a lot of money.
High Annual Cost
Perhaps the most insidious feature of the variable annuity is its staggering annual costs. While the average mutual fund will charge just under 1.5 percent per year (and good funds exist that cost far less), the variable annuity has contract costs, investment management fees, insurance guarantees, and administrative expenses that exceed 2 percent per year. It’s difficult to earn much of a return when the first 2 percent or more of income each year must go to pay the costs of the annuity.
Variable Annuity Death Benefit
The feature that brokers and agents always refer to when defending a questionable recommendation of variable annuities is the death benefit. The death benefit supposedly protects the customer’s beneficiary from loss of principal. Obviously, if your goal is solely to invest for retirement, this feature is worthless since it applies only if you die while owning the annuity. But perhaps it’s important to you to ensure a return for your survivors. In that case, the death benefit theoretically would pay your beneficiary the amount of your deposits (less withdrawals) even if your account has lost money. But the death benefit is very expensive, costing over 1 percent per year, and statistics show that far fewer than one out of ten variable annuities is surrendered due to death. In other words, the insurance company almost never pays the death benefit, despite charging customers a huge annual fee for the feature.
Finally, we come to annuitization, the right to transform your annuity from a variable product into a stream of fixed, regular guaranteed payments. To do this, you must turn the entire value of your annuity over to the insurance company, thereby permanently losing access to your funds. And if you begin annuitization and die prematurely, some or all of your account balance may be forfeited to the insurance company. The truth is that any sum of money can be converted to a guaranteed income stream at any time through the purchase of an immediate fixed annuity, so the ability to annuitize is no reason to buy a variable annuity.
Can You Lose Your Money in a Variable Annuity?
Yes. There are three principal ways to lose money in a variable annuity. First, and least common, is a failure of the insurance company that issued the variable annuity. If the company goes out of business, there’s no one to pay the sums due under the annuity. Second, your money is invested in a number of sub-accounts, which work like mutual funds and are tied to the equity or fixed income markets. Just as the markets go up and down, so will the value of the variable annuity. Third, there are typically high surrender charges involved when you want to gain access to your money in the first years (sometimes up to ten years) after you bought the annuity.
Are Variable Annuities Safe During a Recession?
Not necessarily. Unless your variable annuity has some sort of feature that protects you against downside risk in the market, its value will increase and decrease along with the portfolio of holdings within the annuity itself. The guarantees against downside risk typically bear a high annual cost, and also often limit your upside potential. You’ll often give up the ability to capture the entirety of market gains in order to protect against market losses. In short, variable annuities bear not only market risk, but risk associated with the insurance company that issued the products, and are not automatically immune from dropping in value during a recession.
What Is Wrong with Variable Annuities?
Variable annuities often benefit the person or agency who sells them, not the investor. Variable annuities are often not a good idea because:
- They are not qualified retirement products, so you’ll be investing after-tax monies in them.
- Fees are very high, ranging from 2 to 4%.
- Investment options are usually limited.
- The insurance component of variable annuities – the death benefit – only applies if you die before your account has been annuitized.
- Variable annuities lack liquidity, and often have significant penalties associated with withdrawals.
- Gains on a variable annuity are taxed as ordinary income instead of at a lower capital gains tax rate.
There are a number of questionable practices associated with the sale of variable annuities. If you believe that the broker who sold you a variable annuity misled you, or if the product isn’t performing as you expected, reach out to an experienced investment misconduct attorney today.
Questionable Practices Related To Sales Abuse Claims
- The sale of a variable annuity to a retiree or senior.
- The sale of a variable annuity to someone who knows he or she will need ready access to the invested funds within five years.
- The unnecessary replacement of an existing variable annuity with a new one, creating surrender fees and a new surrender period.
- Failure to disclose fees, commissions, investment risks, and tax consequences of investing in variable annuities, or misrepresenting the facts concerning these issues and others, such as calling the death benefit a guarantee.
- The recommendation to use funds from tax-deferred accounts such as 401k’s, IRA’s, and other retirement plans to purchase variable annuities.
- The unsuitable recommendation of excessively risky or undiversified sub-accounts, leading to loss of value in the annuity.
If any of the above circumstances apply to you, don’t hesitate to contact an investment misconduct lawyer at our firm. Jay Salamon and Hugh Berkson are attorneys at McCarthy, Lebit, Crystal & Liffman who exclusively represent clients hurt by the misconduct of investment professionals. You may have rights of recovery against the variable annuity sales person, his or her firm, or the insurance company that issued the product.