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Some Costs of a Variable Annuity

Question: My father, age 82, has maintained a managed account at a financial services company for a number of years. When his account balance dropped from $150,000 to $100,000 during the past year or so, he became very upset because, in addition to his home, this is all he has. His only income is just over $1,100 in Social Security each month.

His financial consultant told him that the best way to protect his principal would be to purchase a variable annuity. At Dad’s request, I met with the financial consultant who discussed all of the benefits including a death benefit, a guaranteed minimum income benefit even if the account balance was low, tax deferred growth, and long-term care coverage in case Dad needed nursing home care. Although it sounds pretty good, I told Dad that he could not get all of these benefits for nothing and that there must be hidden costs. We are avid readers of your column, and I am sending you this question by email. I would appreciate an answer before we make a decision.

Answer: Based on the facts that you recite, we do not believe that a variable annuity is an appropriate investment for an 82 year-old man. Simply put, a variable annuity is a contract between a purchaser and an insurance company by which the insurance company agrees to make payments beginning immediately or in the future. “Variable” means just that: the principal balance of the annuity will “vary” depending on the performance of the investments your father would choose -- typically mutual funds, bonds, stocks, or a combination. This means that your father’s investment in a variable annuity would be subject to the same market risk as his managed account with several very important additional charges that will further diminish the performance of the annuity:

1) If your father needs to withdraw his money within six to eight years after purchasing the annuity, he will be assessed a “surrender charge” which is the way in which the insurance company recoups the commission paid to the financial consultant who sells the annuity. The surrender charge declines each year. However, your father would be able to withdraw 10% of the account balance each year without penalty.

2) Your father’s account will be charged with a “mortality and expense risk charge” of 1.25% of the account balance per year. This charge is assessed by the insurer to cover insurance risks of the annuity contract.

3) Most insurers also charge “administrative fees” for record-keeping which is generally in the range of 0.15% of the account balance per year.

4) In addition, your father’s account would pay the indirectly fees and expenses charged by the mutual funds which are chosen as investments within the annuity.

5) Also, you are correct in assuming that “there ain’t no free lunch.” There are fees charged for the death, guaranteed income, and long-term care benefits you mentioned which are deducted annually from the account. And if your father moves his investments from one option to another, there may be other fees or sales charges.

6) Some variable annuities offer what are called “bonus credits” by which the insurance company adds an amount to the amount you invest as an incentive to purchase. These “bonus credits” mean higher and/or longer surrender and other charges.

7) With $1,100 per month in Social Security income, your father sure doesn’t need to worry about deferring taxes on his account.

Taking the NextStep: Your father’s financial consultant has the responsibility to disclose to your father the fees and other downsides about variable annuities which space here does not permit us to cover. Since this important information was not provided voluntarily up-front, we question the motives of the consultant other than to earn a commission. Since your 82 year-old Father is not saving for retirement or another long-term goal and may need unfettered access to his money, we do not believe that a variable annuity is a suitable investment for him.



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