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How To Select A Financial Advisor: The Least You Should Know (Part 14A In eBook Series)

How To Select A Financial Advisor - Ed Mahaffy, Little Rock, Arkansas

Chapter 14: Variable & Equity-Indexed Annuities

An annuity is the generic term for a financial product that will make a series of payments to an individual over time. These are known as fixed annuities. The level of payments, the amount of time, and the rate at which payments will increase (if at all) are part of the offer of the specific annuity. They are unique for each individual, but they are based on factors such as how much is invested in the annuity, the annuitant’s health and age (that is, anticipated years of receiving the annuity). Annuities meeting this description
are a source of steady income (cash flow) during a time when the stock market has been very volatile.

Previous chapters described some choices that investors can make about the types of investment accounts they can open, the types of financial advisors they can choose, and the basic financial products they can own. Wall Street has created a multitude of financial products. One of these financial products is the variable annuity. Just reading the prospectus is a herculean task and some “guaranties” may prove unenforceable if certain conditions arise, but
you will only find this information with a keen eye. What the large print gives, the small print can take away. Years ago, when taxation rates for ordinary income and capital gains were much closer, the tax deferral feature of a variable annuity was worth more, which made them somewhat more attractive.

Variable annuities offer certain investment selections, the earnings on which are tax-deferred. The purchaser of the variable annuity is also sold insurance. The insurance component of the product provides some underlying guarantee through a death benefit–value guaranty. They can also be converted to fixed annuities.

Unfortunately, annuities can be expensive, especially variable annuities. Variable annuities are not known for providing value, but they are very popular. Why? Because they offer that guarantee of payment. “Guarantee” is a very powerful word. Two guarantees that are not emphasized are the onerous surrender charges and the exorbitant annual operating expenses. The illustration on the following page depicts the rise in popularity of the variable annuity.

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A guarantee makes anything easier to sell. Variable annuities offer guaranties to protect individuals against certain events, but at a very high cost.

Variable annuities feature lucrative hidden commissions. A detective
would struggle to uncover all the fees in many variable annuities. Ironically, the product is referred to as a “no-load,” and the investor never receives an invoice for any operating expenses, which can amount to 3.0 percent annually. Variable annuities will shake the money out of your pockets faster than an industrial-strength washing machine.

Also, variable annuities entice buyers with a “signing bonus.” A signing bonus—like a professional athlete! The bonus may amount to 5.0 percent or more of the contract or investment value, but don’t be naïve. You pay many times more than the “signing bonus” during the life of the annuity contract through higher annual expenses, or through surrender charges.

Most variable annuities share some common features:

• They are insurance products and investments (securities).
• They feature a “death benefit,” which restores an account balance to a certain level upon the death of the policy holder.
• They can be converted to a fixed annuity that provides steady income for a period of time.
• They offer tax deferral, much like an Individual Retirement Account (IRA).
• All investment gains in the annuity are tax-deferred. But unlike an IRA, the annuity owner is not required to begin taking “distributions” (withdrawals from the account) at age 70½.
• Earnings from an annuity are taxed as ordinary income—a rate that’s typically much higher than the long-term capital gains rate on an investment account.
• Investment choices. The investor can select various investments representing stocks, bonds, and other asset classes, and can change the mix whenever they wish.
• Investors face a 10 percent tax penalty for withdrawing money prior to age 59½. Most variable annuities also offer a range of optional features that an investor can select. So-called ‘riders’ are purchased a la carte for various additional payment guaranties. While these options sound attractive, they will raise the annual costs of ownership. See the illustration below.

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Comparing Tax Rates

In 2020, the rate of federal taxation for long-term capital gains (securities you have owned for more than one year and one day) is 15 percent. By comparison, the highest federal ordinary income tax rate is 39.6 percent. An investor taking a distribution from a variable annuity will pay an income tax of as much as 39.6 percent on any earnings. If that money was instead held in an index fund for at least a year and a day, it would be taxed at the 15-percent federal capital gains rate when sold, unless annual income exceeds $488,000.

Years ago, when the long-term capital gains rates were much higher, the tax-deferral feature of variable annuities presented greater value. Today, much of that advantage is negated by the higher tax on annuity distributions. Again, the highest capital gains tax rate is 15 percent, versus the highest ordinary income tax rate of 39.6 percent.

High expenses. It is not uncommon for the annual expenses of a variable annuity to exceed 3.0 percent. In an investing environment of single-digit market gains and low yields for bonds, these are staggering fees.

High asset management fees. The fees paid to the various investment managers.

Mortality expenses, which are related to the death benefit feature. Variable annuities provide death benefits, which will return the investor’s account or contract balance to a certain value in the event of the death of the annuitant. We are living longer, and life insurance rates have fallen dramatically, but you would never know it by looking at the cost of the death benefit in many variable annuities. If you are reasonably healthy, a simple term-life policy may be much cheaper, assuming that you need more life insurance in the first place.

Very steep surrender charges with very long surrender periods. These are the costs to get out of a variable annuity contract. Surrender charges can be as high as 8.0 percent, and the surrender period can be eight years or longer.

Equity-Indexed Annuities
Instead of offering the annuity-holder a menu of investment options, equityindexed annuities (EIAs) tie the investor’s performance to an index. They are also known as fixed-indexed annuities.

EIAs offer some upside of investing in the stock market, while providing downside protection against losses; however, EIAs are different than variable annuities in some important respects:

• EIAs are strictly insurance products. They are not securities. Therefore, they are not regulated by securities regulators. EIAs are regulated by the insurance departments of individual states.
• EIAs are fixed annuities.
• Surrender charges are high.
• While the investments do track an index, the investor does not participate fully in the upside experienced by the index.
• EIAs do not have ongoing fees. The issuers and retail brokers make their money at the point of sale. Surrender charges ensure that the issuer will recoup the hefty commissions it paid when the product was sold, in case you exit early.

Variable annuities and equity-indexed annuities are just two types of annuities. They should not be confused with other types of annuities, such as “immediatepay” annuities, whereby you give an insurance company a sum of money, and it pays you a certain amount each year for the remainder of your life. When you die, the insurance company may not return any money to your heirs—
even if you die in year one. There are versions of immediate-pay annuities that will pay some portion of your original investment to your heirs when you die; however, any such feature is bound to reduce the income that you receive. So will taking out a policy like this when interest rates are at 60-year lows, so think twice before you hand over your money.

A bond portfolio—properly structured—can provide steady income without any haircut from an insurance company. Unlike insurance products, the portfolio of individual bonds offers transparency, and you will still have your principal.

Variable Annuity: The Vanguard Option
If you are interested in owning a variable annuity, Vanguard Group—the big no-load mutual fund company—offers a relatively attractive product.

Vanguard variable annuities have the following features:

• No surrender charges.
• Annual expenses of approximately 0.25 percent.
• An investment menu of index funds, rather than costly, active Wall Street money managers.
• No gimmicks (such as signing bonuses).
It should be noted that Vanguard annuities do not feature death benefits. Again, for the investor who is seeking life insurance to provide a death benefit for heirs, the answer is to go out and buy it directly, rather than through the indirect method of a costly variable annuity. Visit the following websites for quotes on term life insurance offered by many companies:

For More Information
Annuities are regulated by state insurance commissioners and by the SEC. The National Association of Insurance Commissioners (NAIC) is comprised of state insurance commissioners. If you have questions or complaints about variable annuities, offers links to the home page of every insurance commissioner in the United States. The SEC provides helpful information about variable annuities at

One final word about annuities. Whenever a financial advisor suggests swapping or exchanging one annuity for another—known as a 1035 exchange— you should be skeptical. This sort of activity provides the financial advisor with an opportunity to generate significant additional commissions, it is unlikely to do much for you. The “new and better” annuity is unlikely to feature significantly lower annual expenses, and it will certainly impose its own draconian surrender charges. The exception would be swapping into a Vanguard variable annuity—one without sales charges or surrender charges, and whose annual operating expenses are quite low. This may make sense if you need to protect earnings from taxation, while escaping high operating costs.

Any time a financial advisor recommends exchanging or swapping
annuities (or mutual funds, for that matter), you should request a written explanation of why the proposed swap is beneficial to you. The explanation should include specific figures, such as a comparison of annual expenses, as well as full disclosure of all the advisor’s financial incentives generated by the transaction. As always, read the fine print.

So what’s a viable alternative to variable annuities? How about a sensible asset allocation featuring individual bonds and cost-effective index funds or ETFs to implement the allocation?
In the next chapter, let’s look at another highly-marketed product: actively managed mutual funds.

“Price is what you pay. Value is what you get.”
Warren Buffet, CEO, Berkshire Hathaway

Have a question? Contact Ed Mahaffy.

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Ed Mahaffy

Our first priority is helping you take care of yourself and your family. We want to learn more about your personal situation, identify your dreams and goals, and understand your tolerance for risk. Long-term relationships that encourage open and honest communication have been the cornerstone of my foundation of success.

Our approach is cost-effective and tax-efficient. As an independent investment advisor, we can offer you a personalized financial strategy, not a generic investment program. Your individual portfolio will be based on your unique situation, your values, your preferences and your goals. It will be designed to account for change, in the markets and in your circumstances.

As your professional partner, we’ll work hard to earn your trust and confidence, and provide the advice and service you deserve. Send me a note regarding any questions you may have about any particular investment concepts or products. We’ll get back to you quickly with a thoughtful answer.

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You can reach me directly at or call 501.603.0406

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