Variable annuities are financial instruments sold by insurance companies that have come under significant scrutiny within the financial community for being exploitive of unknowing and/or misguided consumers and recipients of financial advice. In principal, variable annuities have several advantages including no limits on tax deferred retirement savings, management by experienced financial institutions, a substantial range of investment options, beneficiary guarantees, different pay out options, and protection from potential lawsuits. Despite all these benefits of variable annuities, problems still persist, most notably annuity exploitation, financial risks and additional costs.
Annuity exploitation
The primary problem with annuities is the associated fees, commissions and costs. Annuities can earn an insurance underwriter between 5-10 percent in commission making the front end costs significantly high in addition to potential pressure to buy variable annuities from sales persons. Additionally fees associated with variable annuities are typically higher than some other forms of retirement savings.
Due to the significantly high commissions insurance agents can receive from the sale of variable annuities, financial advice may be skewed in favor of variable annuities. This unbalanced financial advice has the potential to not meet individual client needs and may be more geared toward earning commissions than providing proper professional financial advice. In other words, the high commissions earned through sale of variable annuities can lead to annuity exploitation or bad practice.
Financial risks
The increase in costs and added pressure to purchase annuities may warrant second thought despite all the benefits typically associated with annuities. For example, if the return on investment on an annuity averages 9 percent, but the annual operations and maintenance expenses are 3-4 percent the total return is not much higher than a certificate of deposit or Treasury Inflation Protected Securities (TIPS). A summary of the financial risks associated with variable annuities is provided below:
• Money held in an annuity is not FDIC insured
• Costs may outweigh benefits
• Hidden fees such as underlying mutual fund fees
• 5-10 percent commissions
• Potential to affect financial advise negatively
• Higher annual fees than other financial instruments
• Value of an annuity can fluctuate with market conditions
The risk associated with annuity may be worth considering when retirement planning and/or purchasing financial instruments through an insurance provider. Furthermore, since variable annuities are not federally insured, diversifying risk among a number of financial instruments may be advisable if one does choose to enter into a variable annuity agreements.
Peace of mind risks
The cost to piece of mind may not suit one’s individual risk tolerance when purchasing variable annuities. This is so not only because of the lack of federal insurance, but also due to the connection of variable annuities with market conditions i.e. if an economy enters into a recession and a significant portion of an annuities investment is in the stock market, the annuity could decline in value to the point of negative returns. These potential negative returns may in turn trigger additional maintenance and/or management fees making the annuity an uncomfortable investment for some individuals.
For the above reason, assessing risk tolerance and investment goals is key in determining which variable annuity if any is right. If an insurance underwriter is unwilling, or unable to discuss these goals with risk of losing the potential sale of a variable annuity, that insurance package may not be worthwhile. Annuities can be structured during the accumulation phase to be less risky by choosing monetary allocations to go into safer investments such as bond funds, however such allocations may yield little if any return after fees and annual reductions.
Additional risks and costs
In addition to the financial risks and risks to peace of mind illustrated above additional costs and risks also exist. These additional risks and costs have to do with the credibility and financial reputation of the variable annuity provider as well as a host of other potential charges that may be unclear at the time of purchase. Another risk is the lack of adjustment for inflation or increases in the cost of living per an IMF study cited by MarketWatch. Other annuity related risks are listed below:
• Surrender charges
• Underwriter solvency
• Extra feature costs
• Insurance provider risk charges
To elaborate on the above points, surrender charges are costs incurred from withdrawing funds from a variable annuity before the phase out period ends. Surrender charges are an early withdrawal penalty charged by the insurance provider. Extra feature costs and insurance provider risk charges include enhanced benefits that are not standard with the variable annuity and extra premiums that serve as insurance to the insurance company.
Summary
When purchasing a variable annuity it can be advisable to take the time necessary in considering all the benefits and disadvantages of the annuity. The assessment of an annuity may include determining the quality of the insurance company, understanding the fine print and all the potential costs and existing costs and deciding if the annuity and investment products available within the annuity are suitable for one’s investment, and retirement goals in addition to individual risk levels. Insurance providers may be swayed into exploiting the annuity service option when providing financial planning services and thus it can be a good idea to be aware of this possibility when reviewing or meeting with an annuity specialist.
When familiarizing with variable annuities, asking questions and researching until one is completely ready to make a decision may be the wisest way to approach the financial instrument. These beneficial features may ideally be weighed and factored into one’s financial goals, comfort levels, future income requirements, and wishes for beneficiaries. The information and sources provided in this article can assist individuals in the process of financial planning for future and/or retirement needs determine how to go about assessing variable annuities in addition to acclimating those individuals with the potential risks associated with the purchase of variable annuities.