Variable annuities have never been easy to understand. And now, with increased investment options and added features, state securities regulators and consumer advocates are concerned that variable annuities are even more confusing.
They worry that many people, particularly those who are older, don’t understand a variable annuity’s fees and penalties, or even whether the product is right for them.
A variable annuity is a combination investment and insurance product designed to save for retirement. Money in the annuity is invested in stocks, bonds and money market funds, and earnings grow tax-deferred until cash is withdrawn. How well those investments perform determines the eventual payout the annuity owner will receive.
The insurance feature guarantees that if the annuity owner dies before making withdrawals, the beneficiary will receive the annuity’s market value or the principal, whichever is higher.
Variable annuities aren’t for everyone. They are best suited, financial experts say, for investors in high tax brackets who have made maximum contributions to an individual retirement account, 401(k) or similar plan and are looking for another tax-deferred investment for money they won’t need for a long time.
The seller of a variable annuity is required to make sure it’s suitable for the buyer, but that doesn’t always happen, said Kansas Securities Commissioner David Brant.
That’s why state securities regulators are seeking to expand their powers to police sales practices of variable annuities, he said. Proposed changes in the Uniform Securities Act, which most states use as a guide, would permit that.
Variable annuities are regulated by the Securities and Exchange Commission, the National Association of Securities Dealers and, in most states, by the insurance commissioner.
The insurance industry and others say that’s enough regulation for a product that generates few consumer complaints.
“There are already remedies if a person feels they were sold [an annuity] that’s not suitable or they were misled,” said Dennis Merideth, a past president of the National Association of Insurance and Financial Advisors. “I don’t know how adding an additional layer of regulation will protect the consumer.”
Debate over additional regulation will probably continue, but many agree that investors considering an annuity should do their homework and ask lots of questions. The SEC offers advice on variable annuities at www.sec.gov.
Here are tips from regulators and financial experts:
– Shop around. If you decide a variable annuity is for you, check commission-free, low-fee annuities that don’t carry the standard penalty for early withdrawals, such as those offered by the Vanguard Group and TIAA-CREF, suggested J.J. MacNab, an insurance analyst in Bethesda, Md.
– Read the prospectus. This contains information about the annuity, its fees, investments, payout options and features.
– Review fees and penalties. These vary greatly and ultimately affect investment return.
On average, the total annual expense for a variable annuity is 2.21 percent, which covers the cost of the insurance benefit and investment management, according to Morningstar. That compares with 1.37 percent for the average mutual fund. Annuity fees can be higher if you add features, so make sure you need those additional options, Merideth said.
Some annuities carry surrender charges, penalties investors pay if they take money out of the annuity within a certain period after purchase, sometimes seven years or longer. A typical surrender charge is 7 percent the first year after the annuity is purchased and one percent less each year until it disappears.
Most annuities allow investors to withdraw up to 10 percent of the account’s value each year without triggering a surrender charge. Earnings are taxed as ordinary income. Generally, if you pull money out of an annuity before age 59 1/2 , Uncle Sam will hit you with a 10 percent penalty on the earnings.
Experts advise that investors ask brokers or agents selling annuities how they are compensated. Commissions are paid upfront to the salesperson, but the cost is passed on to the investor through annual fees and surrender charges, MacNab said.
– Exchanges. Many sales of variable annuities result from investors who exchange one annuity for another, which can be done without triggering taxes.
An exchange might make sense if the new annuity has better features or investment choices. But make sure switching is worth the cost. You might have to pay a surrender charge to get out of the old annuity, or the new one might have higher fees and surrender charges.
– Look beyond the bonus. In recent years, some insurers have attracted investors by promising to add a “bonus” to their annuity accounts, generally 1 percent to 6 percent of their initial investment. Do the math and review the terms. The annuity might have higher annual fees or larger surrender charges that would make the bonus not worthwhile.
– Unnecessary tax deferral. Some investors buy variable annuities because of the tax deferral. Make sure you need it. Some annuities are sold to investors with incomes so low that they pay little or no taxes, MacNab said. Sometimes, too, an annuity is purchased through an IRA, which also provides tax deferral, she said.
– Check the seller’s background. Because of the complexity of variable annuities, “most people would have to rely on the salesperson to explain all the features,” said Larry Kosciulek, associate director of investment company regulation with NASD Regulation in Rockville, Md.
It’s a good idea to check the background and disciplinary record of the agent or broker selling the annuity.
You can do so by calling NASD Regulation, the disciplinary arm of the securities dealers, at 800-289-9999 or going online at www.nasdr.com.
Also check the insurer to make sure the company is financially strong enough to meet its obligations.
“You have to make sure that company will be around in 20 years,” MacNab said.
