Immediate vs. Deferred Annuities
The first basic distinction among annuities contracts is between immediate vs. deferred.
As we have seen in the preceding blog posts, all annuities are designed to be irrevocably converted into income at some point, by definition.
We might even say that deferred annuities—those that appear designed to grow like bank or investment accounts and offer some access to our principal—are simply waiting to grow up into immediate annuities, at which point our claim on principal goes poof, and we have only a stream of periodic checks where once was a mighty pool of liquidity. Once again, by contract and by design, a deferred annuity is an immediate annuity waiting to happen.
In a moment, we are going once again to pretend that there really is a distinction, but you MUST forever bear in mind that annuities are designed to ultimately convert liquid principal into income according to some contractual scheme. This is a fundamental characteristic of what annuities are. We’ll get into a bit more detail later, and for now will focus on the very basics. Ok, here we go.
Variable annuities – stocks, bonds and other securities in a life insurance wrapper
The second flavor of deferred annuity—though remember that immediate annuities can also be “variable” because the payment is based on securities—is called variable, from the fact that your value—payment in the case of an immediate annuity—can vary based on the performance of securities markets.
In other words, your account will be worth more or less depending on the stock and bond markets.
These products are often called “mutual funds in an insurance wrapper,” and I think that description is a good one.
Variable annuities can be a very expensive way to invest
Unfortunately, in many products, the funds tend to be overpriced and insurance and other costs can get layered on sending total fees to untenable levels. Often, these fees are for unneeded (and sometimes grossly overpriced) features. On the other hand, an extremely low cost no-load variable annuity product is available, often favored by those who prefer fee-only advisors.
Variable annuities – complex and risky….
Variable contracts are usually so convoluted and complex that many owners never really understand precisely what they have.
Here are the salient points: unlike for Equity-Indexed Annuities (EIAs) the risks of gain or loss are as great as when dealing with most any mutual fund family, and will be influenced by your ability (make no mistake, this is your responsibility, not the salesperson’s) to select and maintain funds and investment asset classes which minimize risk and maximize gains.
As many investors sadly learned during past market upheavals, this is no small feat. But proper investment management is another subject entirely.
How life insurance companies make money on your investment in variable annuities
As with fixed annuities, the insurance company is looking to make money on your money.
With fixed annuities, they earn a banker’s spread; invest your money at x% and pay you x% -y%, with y being their profit.
With variable annuities, there are two distinct profit mechanisms: the mutual fund fee markup, and the life insurance cost, which they call the mortality cost.
All mutual funds charge a percentage of investors’ account value to pay bills and make money for the fund. These percentages tend to be much higher in variable annuities (where the mutual funds are called “sub-accounts”) than in fairly-priced mutual funds.
Insurance companies often profit by either putting their own expensive funds in their annuities, or by offering funds from other (usually big-name) mutual fund companies, then jacking up the mutual fund fees.
Study variable annuities prospectuses to discover total costs and risks
Charging 1-2% annually for the mutual fund fee is by no means unusual, and this is before the insurance cost. These fees, both for mutual funds and variable annuity sub accounts, are never accounted for on any statement. You have to dig in the prospectus (and sometimes in a prospectus supplement too) to find out what they are. But trust me, they’re there.
Life insurance costs in variable annuities can be high
The mortality (read life insurance) cost is included because annuities, being dim life insurance contracts, guarantee that at least the value of your initial investment will be paid to your named beneficiaries at your death.
So you have insurance, equal to your premium payments minus current annuity value, if you happen to die at a time when your annuity is worth less than you paid for it.
Watch out for variable annuity riders which can really jack up costs
Lately, the insurance companies have gotten very creative at offering additional insurance features via riders at substantial, additional costs. But this is the basic premise. Like the mutual fund fees, these insurance charges are never accounted for; so, most people don’t realize they exist.
A mortality charge of 1.25% is very typical, and would equate to $6,250 per year in insurance charges on a $500,000 annuity. Remember that the amount of insurance is only the difference between the total investment and the value on the date of death; much of the time, there may be no real insurance at all.
For instance, if we invest $500K and the annuity suffers a huge drop to $400K AND WE DIE, there is $100K of insurance. Whenever the value is equal to or greater than $500K (and the longer we own it before dying, the greater the odds that the value will be greater than what we put in) there is no insurance.
Of course, those mortality charges keep coming out. In this example, $6,250 a year.
Contrast that with the going rate for term insurance: a healthy person of age 66 could buy $100K of insurance for something like $400 a year, with no rate increase for 10 years. He or she could die at leisure (market up, market down, no matter) and still receive a death benefit. In fact, they could buy over $1.5 million of such insurance, and still not pay as much as the hidden mortality charges in the annuity example above.
Is the life insurance benefit in variable annuities an illusion?
So on variable annuities, the insurance company makes money (without any investment risk, I might add) in two principle ways: mutual fund fees and insurance charges. Two percent a year is probably a fair average estimate and not too far off the estimated “banker’s spread” they make on fixed annuities.
And lest you think 2% is trivial, know that on a $500K investment, 2% more is 100K more in 10 years, and $250K more in 20 years. And 2% less via extra fees means so much less, as well.
Total variable annuities costs can exceed 5% a year and be hard to spot
Bad as this is, many “full-feature” variable annuities cost upwards of 5% a year with all the bells and whistles. Even for those who need the features that can be prohibitively expensive. And for those who don’t, it can be tragic.