Do variable annuities make sense for retirement saving?

Folks:

When I was in my 20s the end of a calendar year was a time to eat 12 plates of food at family dinners. Now it is an occasion for tax and retirement planning. So sad…

I’m poking around looking at ideas that might be better than just sticking money in a taxable S&P 500 index fund.

What I would really like is what state government workers get, i.e., a pension that starts sending me monthly checks when I turn 65 years old and adjusts those checks to account for inflation. So far I haven’t found a product like that. Does it truly not exist? If so, it is interesting that Detroit thought that they could provide this to their workers without going bankrupt. If Goldman Sachs and the rest of the Wall Street geniuses can’t figure out how such a product should be priced, why did states and cities think that they could do what the world’s most sophisticated financial services industry could not?

Insurance companies offer annuities, but they start paying immediately and don’t adjust for inflation. I’m 50 now. By the time I am 65 what seemed like a fat annuity check today might be the price of a Diet Coke. (Note to folks who ask why insurance companies can do this without going bankrupt as Detroit did… life insurance companies save money on their insurance polices when human lifespan is extended so they can use those savings to keep paying annuities that they have promised. When General Motors went bankrupt their oldest pensioned worker was 115 years old and GM had no way to benefit financially from people living longer.)

The “variable annuity” is something that I can’t figure out at all and I want a reader to explain it to me. The basic idea of a variable annuity is that you put money into it today and the investment returns compound tax-free until you decide to start taking money out for retirement income. Vanguard sells them at what they claim (source) are low fees. It turns out, however, that “low” means at least 0.5 percent per year more than the fee on a corresponding index fund. As the S&P dividend yield right now is 1.9 percent (source), that means that one quarter of the yield is raked off to pay Vanguard and its insurance company partner. This sounds suspiciously like paying taxes on qualified dividends plus the new Obamacare rake. If yields were 10 percent and tax rates on dividends were 40 percent this product would make sense to me. But if all of the benefits of tax deferral accrue to the insurance company and/or Vanguard, why go to the trouble and take the risk that the insurance company (think AIG!) will go bankrupt between now and when you need the retirement income?

Are people still buying variable annuities in this low-yield environment? If so, why?

[Oh yes, if you're looking for a little humor from the financial services industry, here's a gemĀ from the Vanguard web site: "Note: The American Taxpayer Relief Act of 2012 (ATRA) raised the top marginal income tax rate to 39.6% and the top capital gains tax rate to 20%." (emphasis added)]

6 Comments

  1. Mr. Finance Dabbler

    December 22, 2013 @ 10:01 pm

    1

    If you’re planning to buy and hold equities until you’re 65, an annuity may not be the best product for you. The benefit of an annuity is the tax deferred compounding, however when you start taking distributions your gains are taxed at your then marginal tax rate. If you held equities in a taxable account, then when you sold at 65 (and beyond) you’d pay the long term capital gains tax. Given current tax rates, the taxable account for equities is likely better, though this analysis depends on (i) your view of the dividend yield on your equity investments which will of course be taxed at your current marginal tax rate (ii) your view on the likely capital gain between now and your retirement and (iii) the tax rates (capital gains and income) in effect when you start taking distributions. If you’re going to buy bond funds then the annuity starts to make a great deal of sense. Equally so if you’re planning on being a market timer and switching between bonds and equities (not advisable though).

    BTW, my understanding is that the 0.47% on the Vanguard Variable Annuity – Equity Index Portfolio is the total charge i.e. includes both the fund management expense and the mortality/insurance aspect.

  2. George

    December 23, 2013 @ 12:55 am

    2

    Your best bet for retirement income is to buy a property, and rent it. This will pay you handsomely if you can do it in such a way that the mortgage is fully paid when you retire. As far as I know, nothing beats it, which is why I have done it, but if your readers prove me wrong, I like to hear it.

  3. philg

    December 23, 2013 @ 1:02 am

    3

    George: Buying property sounds like a great low-risk idea. Certainly much better than exposure to the world economy through the multinationals of the S&P 500. I only wish that I could travel back in time 30 years and purchase commercial property in Detroit. By now the mortgage would be paid off and I would be living the dream….

  4. jay c

    December 23, 2013 @ 6:07 am

    4

    Okay, I am not an expert with these, but I manage my investments myself. The thing with variable annuities you are basically buying insurance. This is a deferred variable annuity. Say you sign up for this thing. After 1, 2, 3…n years, how much of your money can you get back if you don’t like it? What happens if you die during the accumulation phase? Can your kids get the money? What advantage does this give you over choosing (index) investments yourself and rebalancing once a year?

    A lot of moderately successful people have used them in the past as a tax management strategy, but it appears that they don’t have those advantages any longer. Very successful heirs (like the Waltons) set up private foundations, art museums and all kinds of scams er. wealth preservation systems that are not available to the average person and will not be legislated out of existence.

    As for ideas besides sticking money in a S&P 500 index, historically, Venture capital has returned 3% compounded, and movie finance, 2% compounded — that is for sophisticated, connected investors. So rule those out as well as other very illiquid investments.

    I personally believe you can do a decent job managing your investments. And, real estate definitely can have a place in one’s portfolio, but you need to diversify. It also helps if your time horizon is long enough. My aunt owns several properties in DC. The one in NE has gone from angel dust epidemic to crack cocaine epidemic to even worse, a hipster epidemic. One potential tenant said he would rent the place for $3500 a month if we put in a Viking stove (!)

    If you haven’t read these books, I recommend them, as well as the site moneychimp
    The Intelligent Asset Allocator by William Bernstein (don’t get the kindle)
    I used this book to allocate investments in my 401K/IRAs.

    Unconventional Success: A Fundamental Approach to Personal Investment by Swensen — I dislike this author, but the book is worth reading.

    Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice by Sharpe. This is not really aimed at self investors, it seems to be an introductory textbook for financial planners, but it was useful for me to understand designing a portfolio.

    I think I can manage my investments at least as good as a fee only financial planner who charges 1% of assets.

  5. lv

    December 23, 2013 @ 11:02 am

    5

    As a reformed pension actuary, my advice is simple. In general avoid variable annuities, they are complex to design and price, there’s little chance you or your financial adviser will will be able to find will find one with a mispriced benefit. Moreover life insurers got burned recently on some mispriced VA’s so prices adjusted accordingly, and when equity valuations are high, VA sales are brisk. Try not to buy what they’re selling. Complex products hide expenses.
    Look for simple products without a lot of riders (term or life as you need), they are easier to analyze and market is competitive. Look for a simple product, after you used up other tax-deferred options like Roth IRA’s.

    Incidentally (for planning purposes of course) there are some interesting ways to have your kids save money – say you have a small business and your toddler is gainfully employed by your company in the marketing and advertising department, with their adorable faces bringing in lots of business. Suggest to your 1 year old to put away their salary of $5500 into a Roth IRA and they’re 26 years ahead of most people in compounding returns – huge difference)

    Immediate or Deferred fixed annuity from Vanguard is a decent option, usually others are more expensive. Inflation adjusted do (did) exist but they don’t make that much sense. If something like a BBB longer dated bond bonds yield 4.5 percent (Insurance company general funds portfolio), your return may be 3.5% or less and you get a guaranteed income stream you never run out of, that’s the benefit you pay for. Ask for inflation adjusted and they will halve your starting benefit. Expensive and not worth it. You protect against inflation in other ways: with a separate pool of assets, Social Security, like I said don’t make an annuity your biggest asset.

  6. Mark Lutton

    December 23, 2013 @ 10:44 pm

    6

    Buying property: A long time ago I read a college tip: instead of paying rent or dormitory fees for your college-bound son or daughter, buy a house, have your college kid live in it, and rent to 3 or 4 others. After the kid graduates, sell the house for a nice profit.

    Four years later I read a story about how much damage a bunch of college kids can do to a house in four years ….

Log in