Variable Annuities Are the Way to Go!!!!!

[2B]

Those of you who are familiar with my normal comments on annuities may have been surprised by this new thread. Well, nothing has changed but I recently read a pair of articles by Ty Bernicke (see links) that made me want to make me throw up. Ol' Ty has shown that given the right makeup that barnyard pig can be pretty enough to take to the senior prom.

FPA Journal - Variable Annuities: From Controversial to Mainstream Using a Two-Bucket Strategy, Part 1


FPA Journal - Variable Annuities: From Controversial to Mainstream Using a Two-Bucket Strategy, Part 2


My specific criticism is based on his assumptions. An individual "doing it with mutual funds" pays fees of 1.20% on stock mutual funds and 0.9% on bonds. I hope no one on this forum has fees anywhere near those. The VA also has total fees of 2.5% which is far lower than I have seen although things may have changed recently. The VA has a guaranteed payment of 5% of the original purchase price (5% of 80%). The other 20% goes into a "flex" portfolio that is meant to supplement withdrawls when the VA doesn't generate enough extra income. He also compares a 40% bond/60% self-managed portfolio against a 92% equities VA/"flex" portfolio.

Even with this equity advantage, he has to jiggle the results to make them look good. The bottom line "advantage" comes down to the continued "guaranteed" annuity payments no matter what. Although after a few decades, the non-COLA'd payment is probably pretty meager. If this "guarantee" is important, someone could still buy an immediate fixed annuity with a much lower fee although I don't like these either.

Feel free to read these articles if only to educate yourself against the next wave of "research" that "proves" variable annuities are the way to go.

 

[Independent]

I read both articles. Like you, I'm surprised that the VA with its higher expense loads could look better. One possibility is the different asset allocations. He compares the "traditional mutual fund" using a "traditional asset allocation" with the VA two-bucket approach using a substantially more aggressive asset allocation.

My first thought was that he needs to include a third option. That would be the mutual fund (no VA) product choice with the more aggressive asset allocation. It probably outperforms both of the options he tested.

My second thought is that he just messed up the calculations. The way he describes his withdrawals, it seems that the total amount withdrawn each year should be the same in the two methods (it is always the initial $25,000 increased with inflation). In fact, he does a simple one-year example to demonstrate this. If this is the case, than the total amounts withdrawn over the 30 year period should be the same, unless the retiree exhausts all the his funds in one of the methods.

Now in his Table 3, I can see that for starting years 1947-1954 none of the funds are exhaused. Therefore, the total withdrawals should be identical between the two methods. Yet in Table 2, he shows higher income in every one of these years for the two-bucket approach. So at this point I'd say that his math isn't consistent with what he claims to be doing.

 

[2B]

So at this point I'd say that his math isn't consistent with what he claims to be doing.

There appears to be a little smoke and mirrors going on but I'd have to core drill his "assumptions" more aggressively which I don't feel is worth the time.

One thing that bothers me is the typical mutual fund fee being 1.2% and his claim of 2.5% for the VA. He then takes a generic overall mutual fund return and uses it as is claiming the fees are included. He then subtracts 1.3% from this for his VA return. I'd feel more comfortable if something like FIRECalc was used with varying expense ratios.

My basic point in the post was to warn people of new "research" supporting the variable annuity business. I'm sure it will make its way into the VA dinner circuit. If someone gets caught cold with a slick presentation using this, they might make a big mistake.

The worst part is his studied case put 80% of the portfolio into the VA trap.

 

[FinanceGeek]

I personally believe that VAs are a decent method of accumulating tax-deferred retirement savings, but only if you've exhausted utilization of any IRA/401k/427/KEOGH etc. plans available to you, paid off all debt, and then, only then, if you go with a low cost provider such as VG or Fido with no mortality or surrender charges and low expenses (25 bps for Fido, even beats VG!). And because of the lack of basis step-up, you want to withdraw from your VA account first in retirement and/or gift it to charity.

One very reasonable use of a VA is for parents and grandparents to bequest money to young children, who have no earned income and would be taxed in a high tax bracket if their ancestors simply gifted them funds in a taxable account (thanks to "kiddie tax"). Properly structured a VA will avoid making the child ineligible for college financial aid and to boot VAs are generally protected to some extent against any future judgement creditors.

 

[2B]

I personally believe that VAs are a decent method of accumulating tax-deferred retirement savings, but only if you've exhausted utilization of any IRA/401k/427/KEOGH etc. plans available to you, paid off all debt, and then, only then, if you go with a low cost provider such as VG or Fido with no mortality or surrender charges and low expenses (25 bps for Fido, even beats VG!). And because of the lack of basis step-up, you want to withdraw from your VA account first in retirement and/or gift it to charity.

One very reasonable use of a VA is for parents and grandparents to bequest money to young children, who have no earned income and would be taxed in a high tax bracket if their ancestors simply gifted them funds in a taxable account (thanks to "kiddie tax"). Properly structured a VA will avoid making the child ineligible for college financial aid and to boot VAs are generally protected to some extent against any future judgement creditors.

No positive VA comments go unrebutted.

I would contend that in almost every case the after tax money would be better placed in a group of diversified index funds. By definition, an index fund does not generate many trading profits that would generate current tax. Dividends also currently receive favorable tax treatment. By letting the profits compound, the eventual sale would be done at the long term capital gains rate while all annuity profits would be taxed as ordinary income.

If there's enough money involved to worry about the "kiddie tax" a 529 plan would also likely be a better place to fund college rather than a VA. A granparent can keep the 529 separate and keep it off the parent financial aid form. If there's enough parent money involved to worry about the "kiddie tax" than the kid probably won't get any need based financial aid anyway.

VAs are a great way to assure an individual's financial future -- if you are the VA salesperson.

 

[FinanceGeek]

If there's enough money involved to worry about the "kiddie tax" a 529 plan would also likely be a better place to fund college rather than a VA. A granparent can keep the 529 separate and keep it off the parent financial aid form. If there's enough parent money involved to worry about the "kiddie tax" than the kid probably won't get any need based financial aid anyway.

VAs are a great way to assure an individual's financial future -- if you are the VA salesperson.

Well, I am not a VA salesperson, in fact not selling anything, just trying to be objective...which I sense you're not by your comment that no positive VA comments go "unrebutted", so perhaps I am wasting my time pointing out that there is a narrow area where VA's may make sense?

I concede your first point but only so long as tax rates stay low on dividends and capital gains relative to wage income. But that hasn't always been the case in my lifetime, and its awfully hard for me to believe with today's "soak the rich" political landscape and untenable government deficits that it will remain so for my lifetime, forget the lifetimes of my grandkids. When the baby boomers start leaving the workforce en-masse, I'm pretty sure we'll see a big push to re-position the taxation system to "follow the money" accordingly and preferential tax treatment of income "that only rich people have" will be little but a fond memory.

As for (grand)children being bequested money via a VA, I still think its preferable to a 529 since its more likely to enjoy additional decades of tax-deferred compounding. 529's are really intended for educational expenses whereas by gifting descendants a VA you can set up *their* retirement decades in advance far more efficiently than gifting them assets which will disqualify them for financial aid OR require payment of current taxes at their parents bracket.

It doesn't do very much good to set up a 529 and have it wind up with a few hundred thou as it would to see millions accumulate in a VA over the course of 50+ years. Yes, it is tax deferred and the contribution limits are generous (you can lump several years of gift tax exclusion together). But - as for your comment about financial aid, recall that grandparents assets are not subject to financial aid review...whereas a 529 with several hundred thou or better is certainly not going to go unmolested...what else can you spend it on without penalty except education anyway? Whereas a VA held in an irrevocable trust with a spendthrift clause is really in place for the grandchild's eventual retirement and can easily enjoy 5 or 6 decades of tax-deferred compounding.

By the way, Paul Merriman is pretty much against VA's, as well, but he agrees that they may make sense for children and grandchildren when planning one's estate. He is definitely not a VA salesperson. Have a look at his article: FundAdvice.com - My 500-year estate plan

 

[2B]

Well, I am not a VA salesperson, in fact not selling anything, just trying to be objective...which I sense you're not by your comment that no positive VA comments go "unrebutted", so perhaps I am wasting my time pointing out that there is a narrow area where VA's may make sense?

I would be happy to have some new information that could change my mind on a specific variable annuity that made financial sense. I just haven't seen one. Fluffy "what abouts" are not specific new pieces of information.

My siblings and I are the victims of a VA salesman that had our father stick his life savings into a VA. The fees are north of 3.5% and the money is tied up for several more years. Rather than getting it "tax free" if it had been in his personal estate, we will have the honor of paying ordinary income tax on a couple hundred thousand dollars. My FIL was also annuitized in a piss-poor product loaded with fees. Hence, my position on VAs is bought and paid for.

I concede your first point but only so long as tax rates stay low on dividends and capital gains relative to wage income. But that hasn't always been the case in my lifetime, and its awfully hard for me to believe with today's "soak the rich" political landscape and untenable government deficits that it will remain so for my lifetime, forget the lifetimes of my grandkids.

In my lifetime I have never seen a period of time where the dividend and/or capital gains taxes have been above the tax of ordinary income. These have frequently been given favorable tax treatment.

Determining what the tax law will be in the future is more difficult than forecasting the stock market.

By the way, Paul Merriman is pretty much against VA's, as well, but he agrees that they may make sense for children and grandchildren when planning one's estate. He is definitely not a VA salesperson.

In the article the VA was for a token deposit which for the purposes of this article made a bold move to fund his grandson's retirement. It creates impressive numbers but it's really just a variation of "if I had bought xxx back in 1953 I'd be rich today." His real money according to the article will go into a trust with no mention of a variable annuity. That is the way the uber-weathy handle their money. They don't buy VAs. I'm sure his grandson will appreciate the trust much sooner and much longer than the VA.

My and DW's will create trusts for our children. When they get done "grandkidding," I plan on changing our wills to broaden the trusts for them. Unless something really changes, there won't be any annuities in the pot.

 

[FinanceGeek]

I would be happy to have some new information that could change my mind on a specific variable annuity that made financial sense. I just haven't seen one. Fluffy "what abouts" are not specific new pieces of information.

My siblings and I are the victims of a VA salesman that had our father stick his life savings into a VA. The fees are north of 3.5% and the money is tied up for several more years. Rather than getting it "tax free" if it had been in his personal estate, we will have the honor of paying ordinary income tax on a couple hundred thousand dollars. My FIL was also annuitized in a piss-poor product loaded with fees. Hence, my position on VAs is bought and paid for.

OK, dawn has broken over my Marble Head - from the tone of your prior post I had suspected you got burned somewhere along the way by one of the many "bad annuity" deals past and present and now I'm certain of it. My condolences for this poor state of affairs...

The specific proposition I am speaking of is to open a VA for each child/grandchild - as babies - and permitting it to compound tax deferred for 60+ years. The VA is owned in trust with spendthrift provisions, etc. I cannot readily do such a thing with a 529 (at the time I had to make this decision it was also unclear if their tax advantage would be made permanent or not), not everyone has millions to leave for the kiddos in trust funds, but as Mr. Merriman says the potential bang for the buck with $10k is pretty amazing. If one does this with VG or Fido, one gets a contract with no surrender charges, no mortality charge, and minimal expenses above and beyond that of the underlying (index) funds, which isn't very high to begin with.

The way I see it, even if DW and I wind up having to spend all of our $$$ on ourselves in retirement we've done our part to leave the next generations something that will in all probability be worth quite a bit someday. Its not quite as nice as leaving millions in a trust, but we lack the resources to do that (and its not super-compatible with RE anyway), so we did what we could with the tools that Uncle Sam anointed with tax advantages. But, its something, and its comforting to know that what we've left them won't be taxed at their parent's higher rate in the meantime, they won't lose 1/2 or more of it in a lawsuit to a future spouse or other creditor (trust has spendthrift clause), they cannot spend it all on a sportscar at age 18, they will still get it no matter what happens to our money (e.g. their inheritance) in our lifetimes, etc.

 

[ats5g]

For analyses of non-qualified annuities, William Reichenstein's research is pretty damn good. I found Who Should Buy a Non-Qualified Tax-Deferred Annuity? on the web. If you've got a public library around, you should be able to get "An Analysis of Non-Qualified Tax-Deferred Annuities," Journal of Investing, Vol. 9, No.2 (Summer 2000), pp. 73-85 for free.

- Alec

 

[2B]

DUH......

Low cost.......


That ain't annuities.

 

[FinanceGeek]

For analyses of non-qualified annuities, William Reichenstein's research is pretty damn good. I found Who Should Buy a Non-Qualified Tax-Deferred Annuity? on the web. If you've got a public library around, you should be able to get "An Analysis of Non-Qualified Tax-Deferred Annuities," Journal of Investing, Vol. 9, No.2 (Summer 2000), pp. 73-85 for free.

- Alec

Thank you for the link, that is very comprehensive. Although the article is generally not favorable to VAs, it seems that the longer the time horizon is the more sense a VA may make. The possibility of asset protection is gravy.

In the case of buying a VA for an infant - well that's the longest imaginable time horizon I can muster!

 

[FinanceDude]

DUH......

Low cost.......


That ain't annuities.

What about SPIA? Those are low cost, but also low risk to the insurer.........

Whether people like them or not, Social Security and private pensions are annuities..........

 

[2B]

What about SPIA? Those are low cost, but also low risk to the insurer.........

Whether people like them or not, Social Security and private pensions are annuities..........

That's been discussed before but more current members of the forum have missed any threads.

The major difference between annuities and SS/private pensions is that you are stuck with them. Annuities are self inflicted. It's better to have SS and my pathetic pensions than to not have them but I would rather have had the cash upfront. SS and most private pensions are also Federally insured which is a whole lot better than buying an annuity guaranteed by the "full faith and credit" of Mega Leveraged Insurance Company. They have been known of go out of business and leave their customers hanging.

The purchase of a SPIA (Single Payment Immediate Annuity) is something I don't plan on doing. I will admit it has a role as "longevity insurance" but it also has many warts in the form of high fees and low rate of return. I've analyzed some immediate annuities and their rate of return requires a purchaser to live 10 to 15 years beyond their mortality table. Their is also a credit risk I won't ignore. I plan on self annuitizing by delaying SS and with CDs and Treasuries.

FinanceGeek --

I was unnecessarily rude in my last reply and I apologize.

Unfortunately, I believe you too are also a victim. You or your children may not realize it for many years but I truly believe you are. Financial press that is bought and paid for by the annuity industry does not turn these things into good investments.

Ben Stein generates a regular stream of articles on their benefits and most of the other writers also have direct ties with the industy.

 

[FinanceDude]

most private pensions are also Federally insured which is a whole lot better than buying an annuity guaranteed by the "full faith and credit" of Mega Leveraged Insurance Company.

PBGC isn't as funded as you would think........ A common misnomer for most, much like FDIC. Two little known facts about the beloved FDIC folks: 1)In the event of a banking system collapse, they will "negotiate" a settlement time frame of up to 99 YEARS with individuals holding FDIC accounts. Also, the amount in FDIC right now is somewhere in the neighborhood of $115 billion dollars, the only problem is it covers $4.5 TRILLION dollars in FDIC accounts.........not really that funded.........

I plan on self annuitizing by delaying SS and with CDs and Treasuries.

Many people do.........

 

[ats5g]

fyi - here are the PBGC guarantees.

Rational Decumulation by Babbel and Merrill have a table at the back of the paper that shows the present value of the annuity payment that each state guarantees.

It's interesting that the PBGC only guarantees a monthly payment while the states guarantee a present value. Because the present value of an annuity payment decreases as time passes, by the time an insurer becomes insolvement, the state guarantee may actually be better than the PBGC guarantee. Food for thought.

- Alec

 

[FinanceDude]

$22 billion underfunded.........

Nation's pension system faces immediate crisis, changes - May. 17, 2005

 

[FinanceGeek]

FinanceGeek --

I was unnecessarily rude in my last reply and I apologize.

Unfortunately, I believe you too are also a victim. You or your children may not realize it for many years but I truly believe you are. Financial press that is bought and paid for by the annuity industry does not turn these things into good investments.

Ben Stein generates a regular stream of articles on their benefits and most of the other writers also have direct ties with the industy.

Thanks for the apology, I am sorry that you were/are being burned by annuities. Generally I don't like them either, an in fact have only used them in this one case.

Given my desires / requirements for an investment vehicle for children / grandchildren I cannot think of any other vehicle I could have used:

• desire to establish retirement fund for child/grandchildren, e.g. take advantage of not just 10-20 yrs of compounding to college age, but actually 60-70 yrs. Think about it, 70 yrs @ 8% IRR implies something like 8 doubles (rule of 72), so $100k could turn into $25.6 million
• my gift recipients cannot utilize traditional retirement vehicles such as IRA/Roth IRA/401k etc. due to lack of earned income
• desire to avoid child paying kiddie tax (this alone rules out nearly any taxable investment unless it was something like Berkshire which pays no dividends)
• desire for some level of asset protection against possible future ex-spouses, teenage car accidents etc.
• desire to not preclude a chance at college financial aid eligibility even though such eligibility is far from certain
• desire to diminish my estate with gifting "while I have the funds to do so", future value of estate is highly uncertain and has a good chance to be substantially lower than it is now
• desire to stick with low cost asset-class allocation approach, not stock picking

I'm sorry you got burned on annuities in your personal situation, I agree that they are generally over-sold and over-touted and I think the paper the other poster referenced gives a good argument against their widespread use. I went into this knowing many of the considerations that the paper raised and still feel like the VA I chose (at Vanguard) meets my family's goals better than any other investment vehicle could have.

 

[chinaco]

Sorry to dredge this one back up but...

That second article shows some pretty compelling illustrations. Anybody buy into it?

I know VG has a low cost VA, I think T Rowe Price also has a low cost VA.

I believe there is a bit of an increased risk by having your contract with one company.

But, at the same time, the pooling of money effect has a benefit also.

A few observations:

1) Long-term capital gains is less than income tax. Net of taxes, I am not sure the Two Bucket strategy is better.

2) 80% in a VA seems like a bit much.

3) Those Annual Step-up options look attractive, but I wonder if they are really very effective. I might be misinterpreting how that option works. I suppose if there were a large protractive market drop, it might be helpful. But still, if there is huge tax overhang, who is going to pull their money from the account all at once. I suspect that from a practical matter, you would stick with your allocations stay invested.


The notion of taking more risk in the VA than one would otherwise take is interesting. The obvious down-side is that gains will be taxed as income, one loses some flexibility, expenses are higher.

I had always looked at a SPIA as a quasi-bond substitution with a longevity hedge (pooling of money). But it had not occurred to me to think of using a VA the way Bernicke describes in the article.

 

[Running_Man]

The major difference between annuities and SS/private pensions is that you are stuck with them. Annuities are self inflicted. It's better to have SS and my pathetic pensions than to not have them but I would rather have had the cash upfront. SS and most private pensions are also Federally insured which is a whole lot better than buying an annuity guaranteed by the "full faith and credit" of Mega Leveraged Insurance Company. They have been known of go out of business and leave their customers hanging.

Could you name a few of the annuitities that have gone out of business and not been paid their customers out? I am aware of several situations where the annuity payments were temporarily slowed and % held back but in those cases annuity holders eventually got their money. Additionally most states provide insurance for up to $100,000 as far as I know.

I am personally aware of several individuals that took cash in lieu of pension and lost all their money, but noone that took an annuity and lost their money.

 

[FinanceDude]

Could you name a few of the annuitities that have gone out of business and not been paid their customers out? I am aware of several situations where the annuity payments were temporarily slowed and % held back but in those cases annuity holders eventually got their money. Additionally most states provide insurance for up to $100,000 as far as I know.

I am personally aware of several individuals that took cash in lieu of pension and lost all their money, but noone that took an annuity and lost their money.

Hey a lot of banks have failed to, but it seems everyone thinks that "A bank had never failed since the Depression".........

It's just that other banks extend their FDIC coverage to the depositors after the receivership hearing is over..............

If you use the big companies, the chances of default are small.......most large insurance companies are not run by stupid people..........

 

[friscokid]

First post here, hi everyone.

Just wanted to point out that this piece is not even approved for public consumption. Typically mutual fund/va pieces written by registered reps require regulator review. Obviously, this one hasn't.

"For Registered Representative Use Only—Not For Public Distribution"

 

[2B]

Could you name a few of the annuitities that have gone out of business and not been paid their customers out? I am aware of several situations where the annuity payments were temporarily slowed and % held back but in those cases annuity holders eventually got their money. Additionally most states provide insurance for up to $100,000 as far as I know.

I am personally aware of several individuals that took cash in lieu of pension and lost all their money, but noone that took an annuity and lost their money.

I'm not aware of any that have gone out of business recently. Unfortunately, I can't remember specifics. The last problem I can remember was some issues in the mid-80's where interest rates fell suddenly and companies that had written annuities based on the high interest rates of the 1970's didn't make it.

I am also not familiar with the level of insurance coverage. You mention $100,000 but is that annual payments, total payments or asset value? I don't know what happened to the annuitants of the failed companies but I remember some sad tales of old people eating cat food because of it. It was also Ronnie's fault.

As for lump sum or annuity pension, having the cash in your hand doesn't protect you from "stupid." I've seen people get large amounts of cash and not have any idea with how to invest and protect it for the future. It's the traditional lottery winner bankruptcy.

As for which to select, I've recommended for people to take both but I usually suggest the "lump sum." It all come downs to the interest rate used to calculate the annuity. Pension annuities are also backed indirectly by the US govt up to a certain amount. If the payment is below this cap, I'd say it's much safer than the typical private SPIA.

Unfortunately in our society, we are all well trained to spend and not save. The purpose of this forum is to help people to save and invest. If we can't do any better than steer people into SPIAs and VAs, we should just shut it down and find something else to talk about.

I may take a hiatus from my annuity posts and simply encourage people to buy them since my index funds have a lot of insurance companies in them that make a significant amount of their profits from annuities. By discouraging "marks," I'm costing myself money.

 

[FinanceDude]

I'm not aware of any that have gone out of business recently. Unfortunately, I can't remember specifics. The last problem I can remember was some issues in the mid-80's where interest rates fell suddenly and companies that had written annuities based on the high interest rates of the 1970's didn't make it.

Jackson National Life comes to mind. They got into hot water for DEMANDING that single premium whole life clients pay additional premium because the fixed income markets whipsawed them. DW's dad had one and he refused to send them more money. Eventually they paid a big fine and moved on.........

Interesting unrelated fact, during the great Depression, NOT ONE insurance company OR mutual fund company failed............

I am also not familiar with the level of insurance coverage. You mention $100,000 but is that annual payments, total payments or asset value? I don't know what happened to the annuitants of the failed companies but I remember some sad tales of old people eating cat food because of it. It was also Ronnie's fault.

I am not aware of the state providing insurance for individual annuities, I think they might back up state pensions or something as an option. If Prudential fails, your annuity is NOT backed up by anyone.........

Pension annuities are also backed indirectly by the US govt up to a certain amount. If the payment is below this cap, I'd say it's much safer than the typical private SPIA.

Definitely the case, but MOST Americans don't have a govt pension to rely on.........

Unfortunately in our society, we are all well trained to spend and not save. The purpose of this forum is to help people to save and invest. If we can't do any better than steer people into SPIAs and VAs, we should just shut it down and find something else to talk about.

Agree, but with a caveat. If people DON'T SAVE, and DON'T LIVE LBYM, it really doesn't matter what products are out there, good or bad. They're screwed anyway.........

I may take a hiatus from my annuity posts and simply encourage people to buy them since my index funds have a lot of insurance companies in them that make a significant amount of their profits from annuities. By discouraging "marks," I'm costing myself money.

I think one could buy the individual stocks of large insurers and get lost on Gilligan's Island for 20 years and still make money........

 

[Dawg52]

I may take a hiatus from my annuity posts and simply encourage people to buy them since my index funds have a lot of insurance companies in them that make a significant amount of their profits from annuities. By discouraging "marks," I'm costing myself money.

Hey, good point. Might be a good idea to pump up annuities for our portfolio's benefit.

 

[brewer12345]

I am not aware of the state providing insurance for individual annuities, I think they might back up state pensions or something as an option. If Prudential fails, your annuity is NOT backed up by anyone.........

Not true. Every state has a state guarantee fund that all the insurers doing business in the state pay into. In the event a failed insurers assets don't cover policyholder liabilities, the guaranty fund is supposed to make up the difference. Its a far cry from FDIC insurance, but t is something.

If you shop carefully and are choosy about the insurer, credit risk is de minimus. The problem is that annuities still tend to be a lousy deal for the buyer.