Investor Alert: Making Informed Decisions with Variable Annuities

From the Desk of Jim Eccleston at Eccleston Law LLC:

A recent FINRA alert does an admirable job describing variable annuities. Variable annuities can offer investment features that guarantee income for life, provide tax deferred treatment of earnings, and death benefits. However, investors should be aware of the restrictive features, taxes and charges, and guard against aggressive sales tactics. The marketing techniques of some sellers require careful inspection, as they have been known to scare or confuse investors with claims that are rarely based on facts.

Understanding variable annuity products can be challenging. There are a variety of features that can be confusing for an investor, especially when facing a “hard-sale” salesperson. Prior to considering a variable annuity it is important to carefully review all of the features in order to fully understand the terms. Consider this list of key items on which to focus:

Liquidity and Early Withdrawals

As these are long term investments, taking out money early can result in losses. In most cases accounts are subject to surrender charges during a period that usually lasts 6 to 8 years. Further, withdrawals before the age of 59 ½ are subject to a 10% tax penalty in addition to the income tax associated with the gain.

Sales and Surrender Charges

The majority of variable annuities have a sales charge associated. In most cases it is not front-end, but instead an asset-based charge. The charges usually begin at a starting point of 7% for example, and they decrease by 1% each year after until zero. So the longer an investor holds the shares, the closer he or she comes to eliminating sales charges.

Fees and Expenses

Variable annuities can be subject to many different types of fees on top of the sales and surrender charges. Mortality and expense risk charges are used by the insurance company to cover guaranteed death benefits, payout options such as guaranteed income for life, or caps on administrative fees. Administrative fees are often applied for record-keeping and other administrative expenses. Subaccounts in the annuity create the need for additional underlying fund expenses. The diverse structuring for variable annuities leave the possibility of charges for various other special features such as stepped-up death benefits, guaranteed minimum income benefits, long-term insurance, or principal protection. Together these fees can amount to 2% of a variable annuity. If these features are not important, investors must consider whether a variable annuity is appropriate.

Taxes

Variable annuities allow for tax deferment which is typically a large selling point for the product. But investors should remember that 401(k)s and other before-tax requirement plans not only defer taxes, but also reduce taxable income. For this reason, most investors should consider variable annuities after having contributed the maximum amount to their 401(k)s. Additionally, earnings from the annuity are taxable at the ordinary income rate, rather than the lower rate for capital gains. Finally annuities do not receive a “step-up” in cost basis upon the holder’s death. The beneficiary will have to pay taxes on all of the gains of the annuity accumulated from its purchase.

Bonus Credits

In an effort to attract more investors, insurance companies offer bonus credits to investors. The bonus credits add an additional 1% to 5% to the premium payments. But the bonus credits are not free. In most cases they are accompanied by increased mortality and expense charges and longer surrender periods.

Guarantees

Insurance companies often guarantee certain benefits to annuity holders such as death benefits or guaranteed income. It is important to remember that the guarantees are only as good as the company guaranteeing them. Although it is uncommon, some agencies are unable to meet obligations. Make sure to check rating agencies before making a large commitment.

Variable Annuities within IRAs

IRAs themselves provide tax advantage that offset those tax advantages of the variable annuity. Therefore, a variable annuity within an IRA will only subject the holder to increased IRA expenses, while generating fees and commissions for the broker. Additionally, traditional IRAs require that you begin withdrawing at 70 ½ regardless of the surrender charges that may apply.

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Investors should be comfortable asking their broker questions regarding any of those topics. Making an informed decision will ensure that the product is suitable. If not suitable, investors may be able to seek legal recourse.  

The attorneys of Eccleston Law LLC represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 65 years in delivering the highest quality legal services.

Related Attorneys: James J. Eccleston

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