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SEC Cautions Against Purchasing Variable Annuities
he SEC recently issued warnings to investors considering purchasing variable annuities. The SEC has prepared a brochure, available at the website www.sec.gov, which discusses the benefits, risks and costs of variable annuities. Investors should read it carefully.
As most investors may know, a variable annuity is a contract between the investor and an insurance company. The insurance company agrees to make periodic payments to the investor beginning immediately or at some future date. Variable annuities are “variable” (as opposed to fixed) because the amount of payments that the insurer will pay the investor depends upon the return that the selected investments generate. As their investments, investors can choose from among a wide range, including mutual funds.
No doubt, investors considering the purchase of a variable annuity will hear the benefits of the product. They principally are: tax deferral, periodic payments for life, guaranteed death benefits and the offering of a wide range of investment options. But what about the risks and costs of variable annuities?
The SEC brochure highlights several risks and costs. First, the SEC cautions that, for most investors, it is prudent to make the maximum allowable contributions to IRAs and 401(k) plans before investing penny one in variable annuities. That is because IRAs and 401(k) plans offer the same kind of tax deferral without the risks and costs of variable annuities.
Second, the SEC warns that a variable annuity offers investors no additional tax advantage when bought through a 401(k) plan, IRA or other tax advantaged retirement plan. Thus, investors should not consider purchasing variable annuities in a tax advantaged retirement plan unless they are attracted to the other features of the variable annuity. These features include receipt of lifetime income payments, death benefit protection or long-term care insurance, all within the variable annuity. Of course, these features may or may not be important to investors.
Third, the SEC cautions that investors are paying extra costs to have these and other features in place. The SEC urges investors to understand the charges. Also, the SEC recommends that investors consider whether they can buy the benefit more cheaply as a separate product. An example cited is the purchase of a long-term care insurance policy, independent of any variable annuity purchase.
Fourth, regarding costs generally, the SEC reminds investors that there are several costs associated with variable annuities, and that these costs will reduce the value of the investment. There are five basic types of costs charged:
- Surrender charge;
- Mortality and expense charge;
- Administrative fees
- Underlying mutual fund expenses; and
- Fees and charges for other features (for features such as long term care insurance).
For example, surrender charges can take a big bite out of returns if the investor withdraws money within a certain period of time after purchase (usually 6 to 8 years, but sometimes as long as 10 years). Surrender charges are a kind of back-end load or sales charge that begin with a high percentage (say 7%) but decrease annually. Contracts often allow investors to withdraw a small amount (10% to 15%) per year without incurring this penalty. Likewise, the mortality and expense risk charge typically is in the range of 1.25% and compensates the insurance company for the death benefit feature of the annuity. Indeed, these are separate costs from the underlying mutual fund expenses.
Fifth, the SEC cautions against making tax-free “1035” exchanges. The tax laws allow investors to exchange an existing variable annuity for another variable annuity without paying tax, either on the income or the investment gains. However, investors may need to pay a surrender charge on the old annuity, and a new surrender charge period begins with the new annuity. Accordingly, investors should compare both annuities carefully. Determine that the new annuity clearly is better, because it has a larger death benefit (if that is an important feature to the investor), or because it has more favorable annuity payout options (if that is an important feature to the investor), or because there is a substantially wider selection of investment choices. Otherwise, do not make the exchange.
Finally, the SEC warns against one of the latest sales gimmicks sparking sales of variable annuities: bonus credits. Bonus credits pay investors money to buy the variable annuity, as much as 5% of the purchase. However, we know that there is no such thing as a “free lunch”. Bonus credits are ill advised because, in return, there are:
- Higher surrender charges;
- Longer surrender periods; and
- Higher mortality and expense risk charges and other charges.
In this regard, the SEC issues two additional cautions. First, the “bonus” may apply only to the initial premium payment or to premium payments that are made during the first year of the contract. Second, some annuity contracts take back the bonus credit payments if, during the first year or thereafter, a withdrawal is made, a death benefit is paid, or other circumstances transpire.
Be careful when considering whether or not to buy (or exchange) a variable annuity.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
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