Variable Annuities: The Financial Sharps Bin

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“Sometimes your best investments are the ones you don’t make.”
-Donald Trump

We’ve all done it in the ED before: It’s a busy shift and we suture someone’s finger but forget to throw away the needles and syringes in our frantic pace to see the next patient. Luckily, the worst that’s ever happened to me is being yelled at by the charge nurse. But there’s a good reason to throw away the sharps—so we don’t get hurt. Unfortunately, there are plenty of investments that can hurt you and which need a trash can of their own. Welcome to the financial sharps bin. In the ensuing months, I’ll discuss some investments and strategies that you should avoid. First needle to throw away: variable annuities.
What is an annuity?
Simply put, an annuity is a stream of periodic payments. If you’re a salaried physician, your income is an annuity, or if you’ve won the lottery (would you still work in the ED?) you have the option of a fixed annual payment for a certain number of years. You can purchase a commercial annuity from an insurance company for two purposes—so that you will not outlive your retirement assets, and to accumulate more assets. Over the past two decades variable annuities, which allow you to accumulate assets, have become very popular, with annual sales in the hundreds of billions of dollars. Essentially a variable annuity is a contract between you and an insurance company whereby you usually invest periodic sums of money during the accumulation phase (early years) and then receive a stream of payments in the payout phase (retirement years).

Love at first sight
Commonly sold by insurance agents and financial planners, variable annuities are marketed as tax deferred savings vehicles for retirement. Much like a mutual fund, in a variable annuity you can invest in various subaccounts which consist of different types of mutual funds, from money market funds to stock and bond funds. Unlike a mutual fund in a taxable account, dividends and earnings on the investment grow without current taxation. Also, if you sell any investments for gain within a variable annuity contract, the gain will also be tax deferred. Much like a life insurance contract, variable annuities typically have a death benefit (usually at least equal to your investment) to beneficiaries so that essentially variable annuities are investment products with an insurance wrapper. Also, unlike most other retirement vehicles, there is no income restriction or total dollar amount restriction on variable annuities, making them seemingly attractive to high income physicians in order to stash away potentially large amounts of tax deferred savings. For example, the 2008 limitation on SEP-IRA contributions (for EPs who are independent contractors) is $46,000, whereas there is no such limitation for contributions to a variable annuity.


Reality bites
While we all want tax breaks, most physicians whom I’ve met have been sold variable annuities make the mistake of equating tax deferral with tax avoidance. Unlike contributions to a retirement plan, you do not receive an income tax deduction for contributions to a variable annuity. While the earnings on your investment grow tax deferred, during the payout phase, the earnings are taxed at your highest income tax rate rather than the more favorable capital gains tax rate when you sell taxable mutual funds. Currently the highest federal income tax bracket is 35% versus 15% for capital gains. Furthermore, much like retirement plans, if you withdraw money from a variable annuity before age 591/2, you will have to pay income tax on the earnings as well as a 10% penalty.

Fees for VAs are even uglier, and they come in a variety of flavors. Total annual fees on VAs can easily run 2-3% or more due to annual mutual fund fees, mortality and expense charges (to cover the death benefit), and administrative fees. Compare that to a taxable mutual, the Fidelity Spartan 500 Index Fund (tracks the S&P 500 index), which has an annual expense ratio of just 0.10%.

Finally, while the guaranteed death benefit provides some insurance to your survivors, it also results in unfortunate tax consequences to your heirs. For example, if you bought a VA for $100,000 and upon your death it was worth $200,000, it is transferred to your survivors as if they had bought it for $100,000. If they subsequently sell the investment for $250,000, they are taxed at regular tax rates on $150,000 of gain. For a taxable mutual fund in a brokerage account, only $50,000 of the gain would be taxed at the more favorable capital gains rates.


The Breakup
So, what are your options if you’ve bought a variable annuity and want out? The first is to liquidate it, but this option entails three adverse consequences: you pay income tax on the earnings, you pay a 10% penalty (assuming you are under age 591/2), and you will pay surrender charges to the insurer of between 5-10%. Surrender charges are like commissions but they are paid upon selling. It’s almost like switching ER jobs and paying a tail for malpractice insurance. The second option is to exchange the annuity into a low load or low cost annuity with annual fees less than 1%. While this still entails surrender charges, it preserves the tax deferral. Finally, you can stop contributing to an existing VA. With this option, any future investment avoids the pitfalls of VAs.

The Financial Pain Scale
On a pain scale, I rate variable annuities a 7 out of 10. While tax deferral is enticing, the annual fees, surrender charges, potential penalties, and limited investment options make them attractive only if you’ve exhausted other investments.

Setu Mazumdar, MD, practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA)

So you ditched the high fee variable annuity. Now what?

Continue next for a few choices…
So you ditched the high fee variable annuity. Now what?
If you’re determined to get out of your existing high fee variable annuity,
there are a few choices which may be better for you in the long run.


1. A few investment companies offer low fee or no commission variable annuities. Two choices here would be VAs offered through Vanguard and T. Rowe Price. The Vanguard Variable Annuity has no surrender charges, and total annual expenses can be less than 0.5%. Similarly, VAs offered through T. Rowe Price can have annual fees less than 1%. In order to roll over to a different VA, you must do a 1035 exchange, which converts your existing VA to the new VA directly in order to avoid being a taxable transaction.

2. Liquidate your current VA and invest in a tax efficient mutual fund in a taxable account. While dividends and capital gains will be taxed to you annually, this option gives you the most flexibility. Also, your annual expenses can be minimal, and you’ll pay lower taxes upon liquidation. Finally, several studies suggest that you’ll end up with more wealth investing in a tax-efficient mutual fund in a taxable account instead of a tax-deferred variable annuity.

3. Contribute after tax dollars to your existing employer sponsored retirement plan (if you are an employee and if allowed) or to an IRA (if your income falls below $159,000 for married couples in 2008).

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