Q. My husband and I have a portion of our retirement money invested in variable annuities, one for each of us held in IRA accounts. We have another in a non-qualified joint account. I have read several of your articles dealing with annuities and what a bad investment tool they tend to be. Too bad I didn’t read these articles before we made our purchase. My husband is 71. He is retired and not in the best of health. I am 66 and want to retire next year. As I understand the contract, we can only remove ten percent of our contract value a year without incurring a withdrawal charge. So, okay, we made this investment choice and it’s probably not the best choice. My question is: What should we do about it? — L.M. by email from Plano, TX
A. You’ve got several choices. Which one you select will depend on the exact terms of your contract and how long ago you made the variable annuity investment. If you made the investment several years ago, it is likely that the redemption penalty that you face will be less of a factor. A typical variable annuity contract has a redemption penalty of about 8 percent in the first year. The penalty usually declines by 1 percentage point a year, disappearing after the 8th year.
The smaller the penalty, the easier it is to think about moving from the high expense investment to a low expense investment. Suppose, for example, you had held the contract for 5 years and your early redemption penalty would be 3 percent of the accumulated value. According to the Morningstar Principia database for variable annuities, the average cost for variable annuity contracts is 2.05 percent. The expense is divided nearly evenly between expenses for the subaccount expense ratio and what they call the cost of insurance.
You could cut your investment expenses to as little as 0.25 percent (Vanguard Balanced Index fund) or 0.61 percent (Fidelity Puritan) or 0.69 percent (T. Rowe Price Balanced), saving as much as 1.80 percent a year. The lower costs of alternatives would help you recoup the early redemption penalty fairly quickly— less than two years for this example.
By moving within a qualified account, such as an IRA rollover, you’ll retain tax deferral for the qualified account and have no tax consequences. Unless you made the investment long ago there probably won’t be any tax consequences for moving the non-qualified variable annuity account to a regular taxable account because it probably has no tax-deferred gains.
If it does have tax-deferred gains and you don’t want to pay taxes on them, you can do what is called a 1035 exchange and move from your expensive variable annuity to one of the low cost variable annuities, such as the one sold by Vanguard.
If your husband is in poor health and the value of your contract is below your original investment, your best course of action may be to stand pat. Why? Because the contract will pay a death benefit that restores the value of your contract to the amount of your original investment. Basically, it functions as (expensive) life insurance.
To make this move you will have to avoid the conventional sales commission driven distribution channel. But firms like Fidelity and Vanguard, both of which offer low cost variable annuity accounts, are well equipped to guide you through the process of a 1035 exchange, if that is the route you choose.
The all-in cost of the Vanguard product varies with each subaccount, but the cost of their balanced fund option is a total of 55 basis points, 29 for the insurance and 26 for the fund. That’s 0.55 percent— about a quarter of what the expensive distribution system costs. You can learn more by going to the Vanguard website and clicking on annuities.
The Fidelity product costs more, but it may work for you if you need to visit a physical office and talk with someone face-to-face. The insurance cost of their annuity is 0.35 percent, only 6 basis points more than the Vanguard product. The comparable managed portfolio, however, adds another 84 basis points so the total cost will be about 1.19 percent. Still, it should save you about 1 percentage point a year.
On the web:
Annuities on Vanguard website
Fidelity Personal Retirement Annuity
Locate a Fidelity office near you
Filed Under: Q&A (from print), Annuities
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