Understanding Variable Annuities: Pros, Cons, and Risks for Retirement

So you know that you own a variable annuity, but you're not really sure how it works. Today, I'm going to walk you through how to understand your variable annuity, what it's costing you, what the benefits are, the pros and the cons, so that you can determine if it's ultimately worth its salt. Hey, I'm Casey Weade, CEO and founder here at Howard Bailey Financial, also a certified financial planner practitioner, and I'm here to help you better understand your variable annuity.

First, I'm going to help lay a foundational understanding of the different types of annuities, so we can ensure that what you have is what you think you have, and then we're going to take a dive into a variable annuity that we audited, and we're going to walk you through how to do that for yourself, so you can determine if it's worth its salt at the end of the day. So first, let's talk about all these different types of annuities, and as I go through this process, please, if you have any questions, anything pops into your mind, drop that right down in the comment section. I'd love to hear your feedback.

I'd love to get your comments and questions and address each and every one of those. So as we look at this spectrum of different annuities, a lot of times we see annuities getting lumped into one basket. Annuities are bad, annuities are good.

Annuities just are. There's a lot of bad mutual funds. There's a lot of bad stocks.

There's a lot of bad annuities. There's a lot of bad life insurance policies, but there's good in all of these different worlds, as long as we get a good one and we're using it for the right purpose. So we have all these different categories of annuities, first and foremost.

The one that most people think of is the first annuity ever created. That is known often as an income annuity, a single premium immediate annuity, a deferred income annuity. This is what we like to call annuitization or a new aside, because what you're doing is you're giving funds over to an insurance company, and then they're going to be guaranteeing you income for the rest of your life.

When you do that, it is going to be a permanent non-revocable decision. We talk about a single premium immediate annuity, that is income starting immediately. If you're putting it into a deferred income annuity, that guaranteed income won't start till one, two, three, four, five years down the road.

But in either case, you are annuitizing those dollars, creating a permanent decision to get guaranteed income for the rest of your life, and that's why annuities were created. They were created to create income for the rest of your life. That is the specific use of these vehicles.

This is the cleanest of all of them, typically the easiest to understand. That doesn't necessarily make it the best annuity, but it is the simplest for us to understand. It's creating that guaranteed income.

There isn't a death benefit. You turn a million dollars over to an insurance company. They give you $80,000 a year.

Two years from now, you collected $160,000. You pass away. Insurance company keeps the rest.

This is why people often say they hate annuities, because they don't want to lose control, and they want to leave something to their heirs. In this instance, you've lost control. There isn't a death benefit, and you have no additional liquidity.

So you're getting that income payment. If you want more income, it's too bad. You're getting that income payment for the rest of your life, maybe the life of you and your spouse, but nothing to your heirs.

These are principle protected. When I say protected, these across the board, whether it's an income annuity, a fixed annuity, a fixed index annuity, they're all principle protected, backed by the claims paying ability of that issuing company, which is why it's so important to always scrutinizing the companies that you're using, especially if you're looking for a lifetime guaranteed income, as you would if you were looking at an income annuity. Then we have fixed annuities.

This might be arguably easier even to understand than an income annuity, because it functions a lot like a certificate of deposit, which most of us have used throughout your investing life. But instead of being backed by the bank, FDIC insured, it's backed by the insurance company, but it functions much the same. You're typically going to have terms of anywhere from two to 10 years, meaning that you have to leave your funds there during that period of time, or you're going to face a penalty for taking more than you're allowed to take.

And there's a death benefit. Typically that death benefit is the account value and whatever it's grown to, minus your withdrawals over that period of time. You're getting a fixed rate of return over a fixed period, whatever that account value grows to, minus your withdrawals.

That's going to your And after that term, it's movable. And obviously it is movable within that term. There's just going to be a penalty.

Typically those penalties start around whatever the term is. So if it's a 10-year annuity, it probably has a 10% penalty in year one, and that often drops by about 1% per year. Sometimes it might make sense to move it early if you can get a better rate on that fixed annuity, for instance.

And the interest that you can actually pull out of there, the liquidity, is often the interest only, much like a CD, or you can sometimes take as much as 10% of the account value every year. And again, that's going to be principal protected. Then you have your fixed indexed annuity.

Fixed indexed annuity, it's kind of like moving along a spectrum of risk as we look across here, right? We're getting the same thing for the rest of our life. We're getting the same thing for a set period. Now we're getting our principal protected, but we are going to have our account indexed to the market.

So we're going to have a little bit more upside. However, we're going to have our principal protected versus jumping over here to a variable annuity. Not to jump ahead though, now our money's in the market, and we're getting all the upside and all the downside.

Here we're finding ourselves with an expected rate of return that's going to land typically somewhere in the middle between the fixed annuity and the market, for instance, maybe even a variable annuity if you have a very low cost one. Then we have our fixed indexed annuity. These terms are typically a little bit longer than your fixed annuities, somewhere between five and 15 years, most commonly 10 years is a term that most people will go with.

The death benefit is going to be your account value, unless as we'll see in just a moment, there's some type of rider or additional benefit that you've attached to the contract for a fee, but at the base level, no other riders, it's going to be the account value that passes onto the heirs. These are going to be movable much the same way a fixed annuity is movable as I just described. And you can take free withdrawals here, typically in the five to 10% range, most commonly 10% of the account value.

Then we also, of course, these are principal protected just like our fixed and our income annuities. Now we jumped to a completely different spectrum. And I say that to the variable annuity because these are regulated securities.

That's one of the things that is often overlooked. We think, well, I own an annuity, it's principal protected, but because it is a security, it is regulated by the securities agencies, be it FINRA or the SEC, it is a security. And being a security, it is a security because your principal is at risk.

These are not regulated securities because your principal is not at risk. That's a really important element for you to understand about your variable annuity. And the terms on variable annuity is typically five to 10 years.

Of course, the death benefit, if there isn't any rider attached to the policy, it'll be your account value minus your withdrawals and plus your gains, movable, just like our fixed and fixed indexed annuities are in the same kind of way. We can typically take five to 10% per year out of those accounts. And as I said, your dollars that you put into that account, they are at risk.

Now, I mentioned that there might be benefits, additional benefits or riders attached to these accounts, income values, death benefits. An income benefit or a death benefit is really the only reason in large part that you would ever own a variable annuity because your money's at risk. If you're going to put your money at risk, why put it in a variable annuity if you're not going to receive other benefits for the additional fees that you're going to be paying? Well, it just wouldn't make sense, right? Unless you really need tax deferral.

If you really need tax deferral because it's not an IRA, maybe you're using a very low cost variable annuity just to get that tax deferred kind of shell that goes over those assets. But most of the time we see people walking in with IRAs in variable annuities paying unnecessary fees. But let's talk about the riders here.

So the riders get attached to these policies and this is kind of how it looks. I always like to draw a little T-chart here. That T-chart helps us understand the different values that you're seeing on that variable annuity statement that you're receiving from the issuing company periodically.

You have your account value on the left side. This is what I often like to refer to as your real money. This is your real money.

This would be the death benefit. This is also what you're going to get to walk away with someday minus any withdrawals plus your gains. On this side, we have your riders.

That might be an income rider. It might be a death benefit rider. Most commonly, it's an income rider.

So that's what we're going to be leaning into today. Going back to that account value, let's say that you had $500,000 that you put in to this annuity with a rider attached to it. Now, if it's a fixed indexed annuity, you're going to see kind of a ratcheted type of growth.

If the market goes up, you'll participate in some of those gains. If it goes down, you won't be participating in the downside. So you'll get a zero in those years, reset, and start growing in the following year.

Then we have our variable annuities that function a little bit more like this. It's the stock market, right? You're typically going to be invested in mutual funds. Some of those really low cost variable annuities have some indexed options like ETFs.

Most often, it's going to be a higher cost mutual fund that you're invested in. And we know the market goes up and it goes down. So that's how that variable annuity functions, the fixed index annuity functions, that account value over here.

What's it going to be in the future? We don't know. It is going to be market dependent. Then we have the income value or the death benefit value.

This is where some of your quote unquote guarantees come into play. And some of those guarantees would be that this account grows at a set rate. Or I've written a couple other acronyms down in here.

That is HAV and HDV. These are common acronyms you might see in a variable annuity specifically. That is highest anniversary value.

So whatever the highest value your account value hits at any given point on your anniversary, it gets locked in and it can't go below that until you start taking withdrawals. The same thing on the HDV, the highest daily value, but instead of on your anniversary value, it's going to lock in at the highest daily value. Then you have what is most common, which is a fixed rate of growth that is going to be applied to that income value.

And that 500,000 in this instance, we're saying, well, if it grows at 7.2% per year. So the company is saying, hey, you can take this half a million dollars, we'll put it in the market. But if it doesn't grow better than 7.2%, that's okay because we're guaranteeing that this value grows at 7.2%. What often is missed, and this is truly why most people end up hating annuities, is because they weren't sold for the right purpose.

They weren't explained thoroughly. They didn't understand them. I can't count the number of times I have individuals that come in that think that their money's growing at a guaranteed 7.2% in their variable annuity, and they think they can walk away with it someday.

Unfortunately, that's not how those income riders work. Now, if this was a death benefit, that 500,000 grows to a million, then yeah, you've got a million dollar death benefit that you'd pass on to your heirs. If it's an income value that 500,000 grows to a million because of the rule of 72, your money doubles every 10 years at 7.2%, then you say, hey, you know what? I want my million dollars because maybe my 500,000 is still worth 500,000.

I want my million dollars. They're going to say, I'm sorry, you can't have the million dollars in a lump sum, but we will let you take it out over time. And they'll usually have some type of withdrawal rate that is dependent on your age.

Maybe it's 4, 5, 6, 7% per year, maybe 7.5%. It's highly dependent on the issuing company. Let's say it's 6% per year, pretty common withdrawal rate. Let's say it's 6% per year on your million, that's $60,000 a year that they're now going to guarantee you should you choose to turn on that income rider for the rest of your life.

So now you have $5,000 a month coming in for the rest of your life. Maybe that meets all of your expense needs and you're happy at the end of the day. But this is just a high level understanding.

Now we have a good understanding of how annuities work in general, how these riders function. Let's take a look at a real life variable annuity and give you a framework of questions to ask and a little math to do so that you can determine if your variable annuity is worth its salt. So we have a variable annuity with Company X issued in 2010.

They deposited in 2010 $400,000. The current account value is $700,000 14 years later. Now that is a growth rate that is not going to be quite 6%.

It's going to be quite a bit lower than that. And they've had these dollars in the market and you're going to see why they've had such a low growth rate in just a moment. They have an income rider on this like we just discussed.

So they have a $900,000 value, which is their income account value. Let's jump over here. So they have $400,000 in that account value.

It's growing to $700,000 over 14 years. They have $400,000 in their income value where it started. It's growing at a guaranteed 6% per year.

That's growing to $900,000. Now, if they want their $900,000, they can take it out at $45,000 a year, 5% of that value for the rest of their one life. So that is one life.

That is the guaranteed withdrawal rate for just a single life. So that means if they turn on this $45,000 for the rest of one of their lives, the owner of the contract's life, and something happens to that individual, then their surviving spouse would not continue to get that $45,000 a year. They would get whatever's left in that account value minus withdrawals plus gains.

On the other hand, if they want a guaranteed lifetime income for both of them, which is almost always the case, we want two lives worth of income, not just one, then they're going to get 4% or $36,000 a year. If they're getting $36,000 a year and they're currently 63 years old, by the time they're 73, they'll have collected $360,000. By the time they're 83, they will have collected $720,000.

Finally, 20 years from now, they get back the money they could walk away with today. By the time they're 93, they have a little more than a million dollars out of that account. It took them 30 years to get a million dollars out from something that they have $700,000 in.

Is that a good deal? No, it's not a good deal. Why is that? See, this is a vehicle that's trying to accomplish too many different things with one vehicle. It's trying to solve for everything.

It's trying to be there for growth. It's trying to be there for income. It's trying to be there for death benefit.

It's a little bit like a duck boat, if you will, those old military boats that go out into the ocean. You know what? They're a little slow on water. They're a little slow on land.

They're probably a little dangerous as well. You got to make sure you got your seat belt on. They're pretty expensive to build.

They're very inefficient. If we want to get a boat, we buy a boat. If we want to get a car, we buy a car.

We don't try to accomplish everything with one vehicle. It's expensive. Let's see just how expensive it is.

So this particular variable annuity, we called the company and we started asking the hard questions. How much is this going to cost? It was currently costing them 1.7% as a base fee. That's what's known as an M&E fee or a mortality and expense charge, 1.7% per year.

Their administrative charges were 0.15% per year. Then their mutual fund costs, we said, how much did the mutual funds cost? They said, oh, about a quarter, 1% to 2% per year. So what's the average? They said about 1% per year.

So their average mutual fund cost is 1% per year. And we have this GLWB. So that is their income guarantee.

That is their income rider. It was called a guaranteed lifetime withdrawal benefit costing them 0.85% per year. That is a total cost of 3.7% per year.

Now, is it really 3.7% though? It's not because this M&A fee, this administrative fee and this mutual fund fee are all being charged against this $700,000 account value. However, this income rider fee of 0.85% is actually being charged against this $900,000 value over here on the right. This is what I refer to as guaranteed increasing fees.

If that is tied to a value that's guaranteed to increase at 6% per year, then your fees are guaranteed to increase every year, regardless of what your real money is actually doing. So once we actually multiply those fees by the values in that contract, we see that this $700,000 account is costing almost $30,000 a year, $27,600 per year, over $2,000 a month, which honestly isn't much shy of the $36,000 a year that they would be getting for the rest of their life, should they turn on their income rider. And that's almost 4% per year, 3.94% per year.

Now, play this scenario out just a little bit, because you might be going, well, I'd be okay to have that guarantee of $36,000 a year. That sounds pretty good, because I'd still have my account value left to go onto my heirs. It's still in the market and growing.

What if the market takes a nosedive? That $700,000 goes down to $350,000. If that $700,000 now drops to $350,000, and we are still drawing that $36,000 out, now we have about $310,000 left in that account value. The market's down, we're still taking income, and we're still getting hit with these charges over here.

This account value is not going to last very long. And the insurance company knows that. They're most likely never going to have to pay out any death benefit to their heirs.

They're going to be able to collect all of those fees, and they're going to give them a little bit of income that might get them back to a break even at some point in the future. So if you have a variable annuity, I'm begging you to take a deeper dive into understanding how that contract works. If you're not sure what questions to ask, how to ask those questions, just call and schedule a free variable annuity analysis with one of the financial planners on our team.

We'll get on the phone with you, we'll walk you through your variable annuity, the pros, the cons, and give you a real straightforward answer on whether that variable annuity is actually worth its salt. All you have to do to schedule that consultation, no matter where you're at in the country, we'll visit with you virtually, is call the number on your screen.