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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 believe 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.

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