The mere mention of variable annuities is enough to set off a heated discussion among financial advisors. Below excerpts from our discussion boards about our coverage of a report from the Insured Retirement Institute. To join the discussion, click here.
Are there ANY VA's that pay on an annual basis? What is the typical advisor compensation model?
by Bradly T.
Coz - the three I use (among top 10 in every anual "favorite of indie's" list) all offer multiple payouts including all up front and no trails, 1% up front with 1% annual and everything in between. They also offer CDSC cycles of 0, 4, and 7 years with 7 years being the least costly for investor and best payout for rep. None changes M&E or rider costs based on rep's comp choice. To date all "cheap" VAs (fairly new and being built for RIAs) do NOT offer any (or many) meaningful advantages to funds/brokerage other than tax deferral (a nonissue for IRAs of course). Top 10 VAs all offer significant death benefits, current and future income benefits, dozens of fund/subaccount spectrum choices from dozens of vetted and top shelf third party managers, DCA, rebalancing, spousal continuation options, and more (all of which does require significant and personalized planning and education) - none of which is available from any brokerage or mutual fund.
Client liquidity and use of appropriate riders per client situation are critical compliance issues. Our firm rarely invests over 30-35% of total portfolio in a VA and often concentrate equity risk of total portfolio allocation into VA contracts for future income bucket allocation. BUT (and this is a BIG but) - most of our clients assets are tax qualified. Putting nonq dollars in a tax deferred vehicle invested in tax favored equities IS problematic.....you are deferring a lower tax into a higher tax (ordinary income) if NOT an IRA.
These contracts have lots of moving parts and significant tax implications, including IRD for nonqs (generation tax transfers have potential negative impact on beneficiaries in higher tax brackets). They can be a powerful and flexible financial tool when used and designed appropriately.....and a horrible and expensive trap when not. Know your carrier, know your product, know your client......FIRST!! Even our old friend Nick Murray endorses their use....but believes their only real value is investor behaviour managers for equity concentration portfolios - "whatever keeps 'em in the market!" No doubt you'll hear some dissenting voices on my opinion.....but I've used them for 20+ years - delivered plenty of death benefit step ups and kept nervous nellies in-market and witnessed excellent performance. When they work, nothing else can possibly deliver what they do. Otherwise, clients pay premiums to transfer risk never realized....the risk retained is the premium paid (contract costs) for the risk insured but not incurred.
by B Smith
LOLOLOLOLOL. Wow. Is this a joke?
by Bradly T.
No, the value of VAs is no joke....as academic studies have much empirical evidence to support their cost-value and their behavioral-finance outcomes (including a positive impact on MonteCarlo simulations). Indeed, many naysayers of a decade ago have changed their tune....including many advisors in the RIA space who still have significant issues with cost and form of compensation. The investing market place is evolving. RIAs are also embracing and demanding (and getting) limited partnerships, nontraded REITs, MLPs, REG Ds, and other types of securities, rebuilt (with par discounts and no commissions) for managed accounts as a way to broaden the market spectrum for their investors.....this is bad? Or simply supply responding to demand?......from the RIA community.
The M&E and rider costs in the stripped/bare bones VAs available now for RIAs are provided by the same insurers who offer more robust features for reps but these products are being upgraded already with far more selection to come. The primary differences in these two similar products for the two distinct channels can be illustrated by the Swiss Army knife: the RIA model is the same chasis with 2 knife blades and a corkscrew while the commissioned model has 4 knife blades and a dozen tools in a larger chasis....same manufacturers, same quality, but very different features and functions. The simple fact is more features and functionality cost more.....regardless of compensation to reps or advisors. Cheaper annuities are cheaper for the same reason cheaper cars are cheaper.
Obviously, VAs are not welcome or embraced by many in the business for many different reasons. But they are primarily and inherently a risk transfer device. If you don't recognize the risk or if you believe the cost of risk transfer is too great, you won't and shouldn't use them. Is the risk transfer premium too high? I wouldn't know. If the risk is realized of course, the answer is no - the benefit was worth the cost. This is an old arguement regarding every form of insurance and both sides have plenty of support for their position. But there have been several studies which demonstrate that market hedging providing similar protection is far more cumbersome and expensive and unavailable to smaller investors. So IF one believes in the risk to be hedged, VAs offer a method for hedging those market, mortality, and longevity risks all reps and advisors are dealing with today.
My opinion is that newer advisors/reps should be very suspicious of their prejudices and any closed mindedness. And that old dogs like me should be even more suspicious of our own...... We each have an obligation to know why we do and believe what we do and believe and we will all are both right and wrong to some degree. I have no wish to convince anyone of my philosophy and methodologies even though I know I'm right!! (that's a joke) Conviction and sincerity on behalf of our client outcomes is far more important than our methods for achieving that end. I certainly respect B Smith's professional committment to client outcomes and welcome other dissenters who are not convinced about the benefits of VAs to reduce risk and keep clients in the market. These vehicles are not cheap and have serious liquidity and tax consequences to manage so there is plenty of room here for dissent and disagreement. But the issue is no joke.
Variable annuities are like mutual funds, CDs, amortizing mortgages, and car insurance. They're financial TOOLS. In some situations, they make sense; in others, they don't. While it's certainly accurate and appropriate to describe variable annuities (especially, in my opinion, when they contain "guaranteed living benefit" riders) as valuable in the construction of a sound financial plan, I stop well short of declaring them to be "key" to such a plan.
I personally have reservations in recommending a VA to be held in a non-qualified account unless that VA includes the insurance element of a "guaranteed living benefit" rider - especially, a guaranteed lifetime withdrawal benefit. Why? Because I believe that the COSTS of a nonqualified VA (with no such rider) are, in general, not worth the benefit one gets for paying those costs.
What are those COSTS? Well, there are the contractual costs, of course. The M&E, subaccount fees, and surrender charges (though surrender charges are only contingent costs from a cash accounting perspective, they surely represent restrictions upon liquidity, so they could be described as "liquidity costs".
There are also the TAX costs. All Ordinary Income treatment of ALL taxable distributions (no Cap Gains treatment available). Plus the 10% penalty tax, unless an exception applies (such as taking distributions after the taxpayer's age 59.5).
I've done many hundreds of analyses, comparing a VA with a NQ mutual fund portfolio, using a tool that lets me analyze the sensitivity of results to changes in key variables (including portfolio turnover rate of the MF portfolio, expense ratio of the MF portfolio and VA, assumed growth rate, and marginal tax rate). In my experience, the envelope within which the VA outperforms is quite narrow. That is not to say that the VA never outperforms, merely that it does so in only a small percentage of the scenarios I've examined.
Of course, when the VA is held in a tax-deferred account such as an IRA or qualified plan, both the All Ordinary Income treatment and the penalty tax are no longer a disadvantage of the annuity, as ALL assets held in such a plan will be subject to those "costs".
I would also argue that when the annuity is not a variable contract, the All Ordinary Income disadvantage is vitiated or even eliminated, as investments properly comparable to a fixed annuity generally get taxed in that way. But the 72(q) penalty tax is still a disadvantage.
When a GLWB rider is added to the VA, the paradigm changes - from what is almost entirely an investment analysis to a risk management problem, where the insurance costs of the rider (and the M&E charges, for that matter) must be evaluated in terms of whether they're worth the risk transfer benefit obtained.
A proper evaluation of that sort should, I believe, look at alternatives such as "contingent annuities", offered by some RIA platforms, as what amounts to "portfolio insurance". At the present time, the availability of such instruments is limited, chiefly because state insurance departments differ greatly in how they view such contracts. NY State views them as an impermissible form of portfolio insurance. Some states call them "annuities"; others believe that they are not.
I agree with the objection to the article's suggestion that variable annuities are somehow indispensable to a proper financial plan, but I believe that they can be, and often are, a valuable component.