Current Pension Topics:
Variable Annuities: Does Cost Produce Any Value?

By JOEL FRANK

Q.: I was wondering why you are not a fan of variable annuities. I have a variable annuity from my old company in the form of a 403(b). You are correct when you say that the fees are expensive. I calculate about 1.5 percent more than a no-load mutual fund. However, I am a "you get what you pay for" kind of person. I have the ability to take income guaranteed for life along with a built in death benefit.

Mr. Frank is a fee-only Retirement Financial Planner and a retired city high school Teacher of Accounting. He can be reached by telephone at (732) 536-9472, or via e-mail at rollover@optonline.net.

D.C.

A.: The most important feature of a pre-tax account is that the taxes on the contributions and profits those contributions are expected to generate are deferred until such time as withdrawals are made. Having said that, the primary goal for the owner of the account should be to maximize investment gain based on a personal tolerance for assuming investment market risk. The most direct way to achieve maximum gain is to get as close to zero-cost (de minimis) investing as possible. This is impossible with a variable annuity because of the mandatory insurance costs. Do these insurance costs add any value to the product? If they do, then the variable annuity should be used. If they do not, then the variable annuity should be discarded. In order to do justice to this question, we must first identify the nature of the insurance benefits found in a variable annuity contract.

First there is the Guarantee Return of Premium benefit. This means if you contributed $10,000 and upon your death the account is worth $8,000, the insurance company must pay your designated beneficiary $10,000. In order for this benefit to be paid, you must die in the short term and during a period of falling equity prices - a Perfect Storm. A well-diversified portfolio is the prudent/sensible way to assure that the value of the account is always greater than the contributions. For these reasons the life insurance death benefit ($2,000) is rarely, if ever, paid yet you pay the monthly insurance premium for as long as you keep the contract. What wastefulness!

The second insurance benefit is the Guarantee of Future Annuity Income Rates. This benefit assumes you will annuitize your balance no later than age 70-1/2, when you must commence Required Minimum Distributions (RMD).

Annuitizing means you sign over your title to your 403(b) balance to the insurance company in return for a guaranteed lifetime income. Is this what you will be doing with your balance? I vehemently advise against it. But let's assume for this discussion that you will annuitize your balance at age 70-1/2. Why pay for it now when you may be decades younger than 70-1/2? I fail to see the value in pre-paying for a benefit that may or may not come to fruition. After all, you may change your mind (last night I decided to have eggs for this morning's breakfast but had a bowl of spelt cereal instead) and use life expectancy tables starting at age 70-1/2, which is my advice. Or, God forbid, you may die prior to age 70-1/2.

When one understands the true nature of the life insurance benefits associated with a variable annuity contract and the probability of never being entitled to receive those benefits, they come to the realization that there is no value added in using the variable annuity for pre-tax retirement investing. D.C., the insurance costs of 1.5 percent that you are paying should be re-directed to grow your 403(b) investment, not to continue to line the pockets of the insurance company. Only you can stop your bleeding!

Assume you are age 25 and decide to keep your $25,000 403(b) variable annuity balance. Assume you earn 7.5 percent annually for each of the next 45 years. Your variable annuity balance at age 70-1/2 will be $648,000.

Now, assume you roll over your $25,000 variable annuity balance to a no-load mutual fund and invest in the same fund. Your 403(b) mutual fund balance will grow to $1,208,000 in 45 years. The difference of $560,000 is the result of re-directing the 1.5 percent you're paying for insurance to the growth of your investment. A very wise move! In 45 years, if you decide to annuitize your balance, your annuity income will be much, much greater because you will be annuitizing an additional $560,000. Please do not take this to mean that I recommend annuitizing. I, most certainly, do not!