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When Are Variable Annuities Useful?

This is the final article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the second article discussed how variable annuities are taxed.

To recap, a variable annuity is essentially one or more mutual funds (or other similar investment options) wrapped in an insurance policy. The insurance aspect of the product creates some unique characteristics:

  • A death benefit,
  • The ability to “annuitize” the policy (i.e., convert it into a guaranteed stream of income),
  • Various optional riders that provide other insurance characteristics, and
  • Unique tax treatment.

Death Benefit

As a reminder, the death benefit is the fundamental insurance aspect of a basic variable annuity. The most common death benefit says that if you die while holding the policy and the account value at that time is less than your net contributions, your beneficiary will receive an amount equal to your net contributions rather than the (lower) account value.

The problem here is that this is such a strange sort of insurance. It doesn’t protect you against loss. Nor does it protect your loved ones in the event of your death as life insurance would. Instead, it only protects if both of those events occur at the same time (i.e., you die and at the time of your death the account value is less than your net contributions to the policy). And even then the insurance only provides enough money to “top them off” (i.e., bring the amount they receive back up to the net contribution), whereas a simple term life policy could provide a much larger death benefit per dollar of premium.

Another key point is that the death benefit is most likely to pay off in the first few years you own the policy, because at least in theory after several years the account value will have gone up. So you can eventually (sometimes quickly) reach a point where it becomes clear that the death benefit will have no value at all, and yet you’re stuck paying for the death benefit (via the “mortality and expense risk fee”) every year for the rest of the time you hold the policy.

It’s not that the death benefit doesn’t have any value. The problem is that there’s nobody who needs exactly this sort of insurance. It’s not an especially good fit for anybody.

A general financial planning guideline is that it doesn’t make sense to buy insurance that you do not need. And the death benefit on a variable annuity is insurance that most people do not need.

Ability to Annuitize

The second insurance aspect of a variable annuity is the option to annuitize the policy (i.e., convert it from a somewhat-liquid asset into a guaranteed stream of income). But that’s not necessarily valuable in itself, because with any other liquid asset you always have the option to sell it and simply buy an immediate annuity with the proceeds.

In other words, the ability to annuitize a deferred variable annuity only ends up being helpful if it helps you avoid a meaningful tax cost on that exchange or if the variable annuity has a meaningfully higher payout than what would be offered on the market for immediate annuities.

Optional Annuity Riders

A variable annuity could be a useful part of a financial plan when a particular rider provides a high value to you relative to its cost. The trouble here is that the value of a rider is usually super difficult to determine.

The insurance company has a team of actuaries, financial analysts, and attorneys working together to create the product in such a way that they feel it will be profitable for them. The consumer, on the other hand, doesn’t have nearly the same level of information or analytical ability.

And when a financial services company has a significant information advantage over the client (that is, when the client can’t really tell whether they’re getting a very good deal, a very bad deal, or somewhere in the middle), it is not usually the financial services company that gets the short end of the stick. This doesn’t mean that you should never purchase a variable annuity, nor does it mean that you should never purchase a rider on a variable annuity. It does, however, mean that you should be very skeptical about whether or not you’re getting good value for your money.

Tax Planning Uses

As we discussed last week, the circumstances in which a variable annuity’s tax treatment would be most beneficial would be something like this:

  • You have a high marginal tax rate,
  • You want to invest in an asset that a) has a high expected return (as measured in nominal dollars rather than inflation-adjusted dollars) and b) does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
  • You do not have room for that asset in your retirement accounts,
  • You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
  • You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).

This is uncommon, but it’s not unheard of. Also, this situation would be significantly more common if interest rates were higher because the annual tax cost of holding regular “total market” bond funds in a taxable account would be greater than it is at the moment.

The most common financial planning use of variable annuities is simply as a replacement for worse (i.e., more expensive) variable annuities that a person has already purchased. As we discussed last week, if you liquidate a variable annuity, there can be undesirable tax consequences. If, however, you exchange that variable annuity (via a “1035 exchange“) for another variable annuity (or a qualified long-term care contract) then you do not have to pay any tax on the transaction.

As a result, for people who have purchased very expensive variable annuities, it is often advantageous to exchange them for variable annuities with lower ongoing costs (e.g., the Vanguard Variable Annuity or the Monument Advisor variable annuity from Jefferson National/Nationwide). A key point, however, is that a 1035 exchange only gets around adverse tax consequences. It does not get you out of paying surrender charges.

Investing Blog Roundup: Cash Makes People Happy

The conventional wisdom of finance indicates that the ideal amount of cash (i.e., checking/savings balances and other very safe, low-return investments) to keep on hand is the minimum amount that is necessary to avoid exposing yourself to undue risk. Anything above that amount should be invested in order to earn a higher return.

This week, however, Michael Kitces draws our attention to a study (pdf here) showing that cash on hand (in the form of checking/savings account balances) has a much stronger correlation to both sense of financial well-being and overall life satisfaction than many other financial measures, including total investments, monthly income, or indebtedness.

In short, holding cash tends to make people happy, even when they have significant other assets and don’t really have a true financial need for a large cash balance.

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How Are Variable Annuities Taxed?

This is the second article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the final article will discuss cases in which they do/don’t make sense as a part of a financial plan.

How a variable annuity is taxed depends on where it is held.

Variable Annuities within Retirement Accounts

If the variable annuity is held in a retirement account, the variable annuity is taxed (almost*) like anything else within that account. For instance, if one of the investment options in your 403(b) plan is a variable annuity, when you defer salary to contribute to the annuity within that plan, those deferrals will reduce your taxable income — and when you take money out of the plan it will be taxable as income.

Taxation of Nonqualified Variable Annuities

If the variable annuity is not held in a retirement account (i.e., it is a “nonqualified” annuity) it has unique tax characteristics.

First, earnings that occur within the account are not taxable while they remain in the account. That is, the account is tax-deferred much like a traditional IRA (but without the opportunity for a tax deduction when you make contributions).

This tax deferral is, generally speaking, a good thing, because it allows the account to grow more quickly. And the greater the expected return, the bigger this benefit is. (Because the greater the return, the greater the annual tax cost that you get to avoid via tax deferral.)

However, when earnings are distributed from the account they are taxable as ordinary income. If you’re using the variable annuity to invest in stocks, this is a big drawback relative to a taxable account, because it means that dividends and long-term capital gains that would have otherwise received beneficial tax treatment are instead taxed at a higher rate as ordinary income.

When your original investment is distributed from the account, it is not taxable. However, all distributions from the account are considered to come from earnings until there are no more earnings left in the account. (In other words, distributions are considered to come in the least favorable order.)

Also, earnings distributions that occur prior to age 59.5 are subject to a 10% penalty, unless you meet one of a few exceptions:

  •  You (the owner of the annuity) have died,
  • You (the owner of the annuity) are disabled,
  • The distributions are part of a “series of substantially equal periodic payments” over your life or life expectancy (or the joint lives/life expectancies of you and a joint annuitant), or
  • The distribution is allocable to your investment in the contract that occurred before August 14, 1982.

Finally, there’s no step-up in cost basis when you die.

Taxation of Nonqualified Annuities, after Annuitization

After annuitizing a nonqualified annuity (i.e., after you convert it from a liquid asset into a guaranteed stream of income, as discussed last week), payments from the annuity are taxed in the same way as payments from any other nonqualified immediate annuity. That is, part of each payment is nontaxable because it is considered to be a return of your basis (i.e., the amount that you put into the annuity), while the remaining portion of each payment is taxable as ordinary income. Eventually, if you live long enough to receive all of your basis back (i.e., the sum of the nontaxable portions of the payments eventually totals your basis), further payments will be entirely taxable.

Tax Planning Considerations

In summary, relative to investing in a retirement account, investing in a nonqualified variable annuity provides only tax disadvantages. It’s essentially the same as nondeductible traditional IRA contributions (i.e., the least desirable type of retirement account contribution) but with two big disadvantages:

  1. Distributions are considered to happen in a less favorable order, and
  2. There’s no opportunity for Roth conversions.

Relative to investing in a taxable account, investing in a nonqualified variable annuity has one tax advantage (tax deferral) and a list of tax disadvantages (distributions of earnings are taxed at ordinary income tax rates when otherwise they might be taxed at lower rates, there’s no step-up in cost basis when you die, and there’s the possibility of a 10% penalty on early distributions).

So when would a nonqualified variable annuity offer a net tax benefit relative to simply investing in a taxable account? The ideal set of circumstances would be something along the lines of:

  • You have a high marginal tax rate,
  • You want to invest in an asset with high expected return and which does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
  • You do not have room for that asset in your retirement accounts,
  • You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
  • You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).

Suffice to say, that situation is very uncommon. Most people have plenty of space in their retirement accounts to hold any high-return, tax-inefficient assets they want to own.

*I say “almost” here because a qualified variable annuity that has been annuitized has slightly different tax treatment than other things within a retirement account. Specifically, after reaching age 70.5, there is no need to calculate an RMD for the annuity. Instead, each year the payment from the annuity is simply considered to be the RMD amount.

Investing Blog Roundup: Do Stocks Outperform Treasury Bills?

Because of the fact that a handful of stocks earn very high returns, most stocks earn returns that are below the average return of the overall stock market. This is not news. (For instance, I wrote a couple of articles about the concept back in early 2009, and it wasn’t a remotely new observation even then.)

A recent study by Hendrik Bessembinder of Arizona State University, however, shows that not only do most stocks earn less than the market’s average return, most stocks even underperform 1-month Treasury bills over the course of their existence. Specifically, Bessembinder looked at the Center for Research in Security Prices (CRSP) database and found that, over the course of their respective lifetimes in the database, 58% of stocks had lower returns than 1-month Treasury bills.

In other words, most stocks are not only risky, they also have pretty poor returns. As Bessembinder puts it, “The fact that the broad stock market does outperform Treasuries over longer time periods is fully attributable to […] the relatively few stocks that generate large returns, not to the performance of typical stocks.”

Personally, I see this as an argument in favor of using index funds to make sure I don’t miss out on the handful of good stocks. Of course, the counterpoint is that if you allocate your entire portfolio to just a few stocks and one of them does happen to be one of those superstar performers, you’re in for a heck of a ride. Still, I’d rather not risk having an “all the risk of stocks, all the return of Treasury bills” outcome.

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How Do Variable Annuities Work?

This article is the first in a three-part series. The second article will discuss how variable annuities are taxed, and the third article will discuss when variable annuities are/aren’t helpful.

A variable annuity can be roughly thought of as a mutual fund wrapped in an insurance policy. That insurance policy creates a few new characteristics, relative to a mutual fund:

  • Unique tax treatment (which we’ll discuss in the next article in the series),
  • Additional expenses, and
  • Some insurance benefits that you get in exchange for those additional expenses.

The insurance benefits include:

  1. A death benefit,
  2. The ability to annuitize the account/policy at a later date (i.e., convert it from a somewhat-liquid account into a stream of income that is guaranteed to last for a certain length of time), and
  3. (Often) one or more riders that introduce other insurance features.

A key point to understand is that all of the above insurance benefits, as well as their associated costs, vary from one policy to another.

The Anatomy of a Variable Annuity

The premium that you pay to the insurance company (whether in one lump-sum or in many payments over time) is invested in one or more “subaccounts,” which are the investment options you’re allowed to choose from (e.g., stock funds, bond funds, or various cash-like options).

Your account value then rises or falls in keeping with the performance of the subaccount(s) that you have chosen.

Variable Annuity Expenses

Variable annuities come with several expenses. First, there are the normal costs of the mutual funds/investment options in the subaccount(s) you choose to use. As with any other time you pick mutual funds, it’s a good idea to seek investment choices with low costs.

The mortality and expense risk fee pays for the insurance aspects of the basic policy (i.e., the death benefit and any guaranteed income options that are included in the basic policy).

There’s also typically an administrative fee, which can be a flat amount per year or a percentage of the account value.

Then, there’s often a surrender charge that applies if you withdraw your money within the first several years of purchasing the policy. For example, I recently reviewed a policy that had a 7% surrender charge for the first two years of the policy’s life, a 6% charge for the next two years, a 5% charge for the next three years, and no surrender charge beyond that point.

The sum total of these fees can vary dramatically from one policy to another. For instance, it’s super common to see variable annuities with total annual fees of 2-3%, plus surrender charges if you take your money out within the first several years. In contrast, the total annual fees for Vanguard’s Variable Annuity are roughly 0.45-0.75% (depending on which funds you choose to use), and it has no surrender charge.

Optional riders (which we’ll discuss momentarily) come with additional costs, which also vary dramatically from one type of rider to another.

Death Benefit

The most basic death benefit guarantees that, if you die prior to annuitizing the annuity (which we’ll discuss in a moment), your beneficiary will get the greater of:

  • The account value (i.e., the value of the underlying investments), or
  • The premiums you paid into the policy, minus any withdrawals you had taken from the policy.

This would be relevant if the account value goes down during the time you own the policy due to poor investment performance.

Income Options

The second insurance benefit that a variable annuity offers is the option to convert the account/policy into a guaranteed stream of income (i.e., to “annuitize” the policy).

When you annuitize the policy, you lose control of the assets. That is, you no longer have the option to take your money out whenever you want.

Most variable annuities come with several income options. Typical options would include:

  • A life annuity that pays out for as long as you live,
  • A joint life annuity that pays out for as long as either of two named people (e.g., you or your spouse) is still alive, or
  • A life annuity with period certain that pays for the longer of your lifespan or a fixed period of time (e.g., 20 years).

A key point is that you do not have to annuitize the annuity in order to start using it for income. Prior to annuitizing, you can take money out whenever you want (though you may have to pay surrender charges and tax costs). You have to annuitize in order to activate the various income guarantees (e.g., to turn the annuity into a life annuity that is guaranteed to pay out for as long as you’re alive).

Optional Riders

Riders are the optional “bells and whistles” that you can add to a variable annuity. They can be just about anything. A few common types of riders are:

  • Features that increase the death benefit in one manner or another (for instance, “locking in” a new value for the death benefit on a certain anniversary date each year if your account value is at a new high),
  • Features that guarantee that you can withdraw a certain amount per year, no matter how long you live, without having to actually annuitize the annuity, or
  • Features that provide a payout if you need long-term care.

Riders naturally have a wide range of costs given the wide range of insurance benefits that they can provide.

Next week we’ll take a look at how variable annuities are taxed. And the week after that we’ll discuss how and when they might be a useful part of a financial plan.

Investing Blog Roundup: What to Do About an Overvalued Market

A concern I’m hearing more and more often is whether the stock market is “overvalued” and, if so, what to do about it. This week, Bob French provides a helpful discussion of the topic:

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