Variable Annuities

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.

There are several risks and costs associated with investment in a variable annuity that many financial advisers do not adequately disclose to their clients.  First, for most investors, variable annuities are high commission products, i.e., financial advisers receive a substantially higher commission when their clients purchase variable annuities as opposed to other types of investment products.

Second, 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.

Third, 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.

Fourth, investors are paying extra costs to have these and other features in place. Also, financial advisers must counsel their clients that it may be possible to 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.

Fifth, regarding costs generally, a financial adviser must clearly explain to 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:

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, financial advisers may unlawfully advise a client to make a tax-free “1035” exchange. 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, financial advisers explain both annuities carefully, and 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, the financial adviser has most likely violated your rights in advising the exchange.

If you suspect that your financial adviser unlawfully advised you to purchase or exchange a variable annuity, or engaged in another sales practice abuse, please contact Wittenberg Law to discuss your legal rights and options.