While earning a guaranteed 5% may sound like a great deal today, historically speaking it's no big deal. If you can lock in 5% for one year, fine. But if you have to enter into a high-cost, long-term insurance contract to get it, it becomes a lot less attractive.
This is my question. My investment advisor has brought to my attention that I can take my current IRA and deposit it into a Pacific Life Variable Annuity. If I understand this there is still a risk because it’s an investment but I’m earning 5% on the guarantee amount. What do you think about this.
Thanks for your input. – Sandy
A variable annuity is essentially a mutual fund wrapped in an insurance company contract. Insurance companies offer tax benefits that typical mutual funds don’t – most notably income tax deferral. In other words, the earnings on variable annuities aren’t taxed until they’re withdrawn. But an IRA already offers tax deferral – you don’t pay taxes on any earnings on your IRA until they’re withdrawn.
So putting a variable annuity into an IRA is overkill, since you’re putting a tax-deferred investment into an already tax-deferred account.
What’s apparently appealing to you in this instance, however, isn’t the tax-deferral aspect of the variable annuity: it’s that you’re guaranteed a 5% return. While that may seem like a good return – and it is, these days – for how many years will that 5% by locked in? How much is it costing you in fees?
That’s important because while that 5% may only be locked in for a year or two, you’ll probably be locked in to the annuity for considerably longer.
The withdrawal penalties for a variable annuity typically last at least 5 years and sometimes up to 10. So if the 5% is only guaranteed for one year, but you’re locked into the annuity for 10…you can see the potential problem. If the 5% guarantee is for the life of the contract, you’re probably paying for it with an annual fee that could be removing 1% or more per year from your investment earnings. In short, there’s no free lunch – you’re limiting your upside by limiting your downside.
And keep in mind that any guarantee you get is only as good as the company making it – there’s no FDIC or other government guarantee.
When I was a stockbroker, we received a 4% up-front commission on variable annuity sales. So if we sold a $100,000 variable annuity, the commission was $4,000 (half went to the brokerage firm). While that was a very long time ago, I suspect the same type of commission structure is alive and well today.
The commission on annuities is paid to the broker by the insurance company (as opposed to taking the money from your investment up-front), but insurance companies recoup it by charging high annual management and administrative fees. I don’t know what Pacific Life charges, but when you combine the plethora of fees, it’s can often add up to 3%/yr. You can find mutual funds that charge a whole lot less. (If 3% doesn’t sound like much, check out this story about what half that amount does to your 401k earnings over time.)
Bottom line? I’d be very cautious. Ask your adviser lots of questions, like:
- What are the fees if I decide to take my money out?
- What annual fees am I paying within this annuity? Please show them to me within the prospectus.
- Is there a place that I can earn 5% over time without locking myself into a contract like this?
- Is the insurance company charging me a fee in exchange for providing that 5% guarantee? How much is it?
- How much are you making in commissions from this investment?
The bottom line…
While earning a guaranteed 5% may sound super today, historically speaking it’s no big deal. If you can lock in 5% for one year, fine. But if you have to enter into a long-term insurance contract to get it, and pay an annual fee that could reduce your earnings, it becomes a lot less attractive.