Variable Annuities: What Federal Employees Need To Know

Federal employees often ask me if annuities are good or bad? And my response is that they’re neither good nor bad—because they’re just tools that work well to meet specific goals and do not work well to meet others.

Thus, the only way to know whether an annuity may be a solution for you is to understand how they work. Annuities are often divided into three distinct categories – fixed, variable, and indexed – and can also be deferred or immediate, meaning they begin paying out on a future date, or payments can start right away.

However, this week we’ll focus on the basics of the variable deferred annuity (often referred to as variable annuities) and their major characteristics.

What Is A Variable Annuity?

So, what exactly is a variable deferred annuity? A variable annuity is a contract between you and an insurance company under which the insurer agrees to make periodic payments to you at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.

Unlike a fixed annuity, with a variable annuity, you’ll be able to invest your purchase payments in a range of investment options, typically mutual funds. An important point to keep in mind is that the value of your variable annuity will vary depending on the performance of the investment options you choose.

Thus, variable annuities may expose you to investment risk, not unlike your TSP or IRA.

How They Work

Unlike variable immediate annuities, which begin payments immediately (within a year), with variable deferred annuities, your income payments will be delayed until a future date.

This delay will give your annuity (which is likely invested in mutual fund like securities) time to grow, which is important because the income payments you’ll receive in the future will be a percentage of your overall annuity value. Thus, you can think of a variable annuity as having two phases: a growth phase and a payment phase.

During the growth phase, you may be making purchase payments, which typically means you’re investing more money into the underlying securities, called subaccounts. And if your investments perform well, your income payments during the payment phase will be larger; however, if they perform poorly, your future payments will be smaller.

Hence, with variable annuities, you’ll often retain the investment risk, which means that, like your other retirement tools (TSP, IRAs, etc.), you bear the consequences of your investment’s performance.

Some annuity contracts offer protection against losses for an additional fee; this is done via riders (more on this next).

When it comes to the payment phase, you’ll typically have a few options to select how you’ll receive your income payments. These payment options usually include a lump sum, a period certain (such as 20 years), or an indefinite period option (such as your lifetime or the lifetime of you and your spouse).

An important point to remember is that the amount of each payment you receive during the payment phase will depend on the length of the period selected (number of years vs. lifetime) and the value of your annuity.

Riders Allow Customization

If you strip a variable deferred annuity down to its basic components, it’s an agreement with an insurance company to either make a one-time payment or a series of payments in exchange for a series of payments at a future date. Does this sound like anything familiar (FERS pension, Social Security?).

However, what makes variable annuities unique and often confusing, is that they can be customized for every individual by purchasing riders. Adding to this complexity is that many insurance companies offer different options with varying fees.

Thus, it would be impractical to attempt to cover every rider offered; however, we’ll look at the most common options.

• Death Benefit: Like other insurance products, a common feature of variable annuities is the death benefit. This benefit is paid upon your death to a person you have selected as a beneficiary (such as your spouse or child). The amount is typically the greater of: (a) all the money in your account or (b) some guaranteed minimum (such as all purchase payments minus prior withdrawals).
  
• Guaranteed Minimum Income Benefits: Another common feature added to variable annuities is the guaranteed minimum income benefit. These riders guarantee a minimum level of income payments, even if your annuity value doesn’t support that level of payments.
  
• Long-Term Care: Some insurers will offer long-term care insurance riders, which pays for home health care or nursing home care if you need support with daily tasks due to chronic illness, injury, disability, or simply the aging process.
  
• Enhanced Crediting: Another common rider offered is “enhanced crediting” or “bonus crediting.” This rider adds a bonus to your contract value based on a specified percentage (typically 1% to 5%) of purchase payments. For instance, if you purchased an annuity with an enhanced credit rider of 4% on each purchase payment and made a purchase of $100,000, the insurer would credit your account for $4,000.

No Free Lunch
As great as these riders sound, they’re no free lunch. You’ll pay for every benefit added, and the cost can add up quickly. Moreover, because the fees vary from company to company, individual analysis is needed to determine whether the benefits received from the rider outweigh the fee paid.

Costs

Likely the most significant disadvantage of variable annuities is their fees, which average around 2.3% yearly. Unlike mutual funds or exchange-traded funds (ETFs), which state their total fees clearly as a ratio of the amount invested, with variable annuities, every fee is stated separately in the policy contract, making it difficult for investors to understand the actual cost of the product.

Some of the typical costs of variable annuities include:

• Mortality Expenses (M&E): This fee is equal to a certain percentage of your account value, typically 1.25% per year. This charge compensates the insurance company for the insurance risks assumed under the contract and also covered the costs of selling the variable annuity, such as a commission paid to the insurance professional.
  
• Administrative Expenses: Many variable annuity policies may also charge an additional fee for their administration expenses. This fee typically ranges from .10% – .30% of the policy value per year.
  
• Investment Expenses: As we discussed, variable annuities have underlying stock and bond investment choices, called sub-accounts, each of which has an investment management fee ranging from .25% – 2.50% of the account value per year.
  
• Surrender Charges: Since most policies pay an upfront commission to the insurance professional who sold you the policy, the insurer puts restrictions on withdrawals to ensure their cost is covered; these restrictions are called surrender charges. Thus, you could be subject to a surrender charge if you need to withdraw a substantial amount or all your money within a certain period after a purchase payment (typically within 6 to 8 years). Generally, the surrender charge is a percentage of the amount withdrawn and declines gradually over several years, known as the “surrender period.” For example, a 7% charge might apply the first year after a purchase payment, followed by a 6% charge in the second year, then a 5% charge in the third year, and so on until the eighth year, when surrender charges no longer apply.
  
• Additional Cost of Riders: As we covered, riders are no free lunch, and every additional rider added to your contract will increase the annual cost. The cost of these extra features can range from .25% – 1.75% of the policy value per year.
  Note: Variable annuities will usually allow you to withdraw part of your account value each year without a surrender charge; this is known as a “free withdrawal.” The free withdrawal will usually range between 10% to 15% of your account value.

It should be clear by now that variable annuities can contain several charges, and often the amount and type of fee can vary by policy. Hence, before buying an annuity, it’s imperative that you understand your total cost.

Final Thoughts

Remember that annuities are just tools and whether they’re suitable for you depends on whether they’ll help you achieve your investment goals. For federal employees who are risk-averse and fear running out of money, variable annuities paired with income riders can provide a floor of guaranteed income to supplement social security and their FERS pension.

For those who have fully maxed out their TSP and IRA annual contributions, the tax-deferred growth, lack of income, and contribution limits can make the variable annuity an attractive option.

However, variable annuities come with tradeoffs, such as investment risks, increased complexity, high fees that can reduce your investment returns, and lack of liquidity. Given these substantial tradeoffs, you should compare variable annuities with other available financial strategies, such as a diversified portfolio, before purchasing.

While we covered a general description of variable annuities, before buying, you should examine the annuity you are considering; this can be done by requesting a prospectus from the insurance company. This document contains important information about the annuity contract, including fees and charges, investment options, death benefits, and annuity payout options.

Additionally, I strongly suggest you consult a fee-only Certified Financial Planner™ for an objective analysis.

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