Variable Annuities: Expensive Protection

Variable annuities are widely marketed to physicians as asset-shielding investments that can offer substantial returns. These investments can hold considerable allure for doctors because assets held within them are protected from malpractice judgments in some states.

“In this world nothing is certain but death and taxes.”—Benjamin Franklin

Variable annuities are widely marketed to physicians as asset-shielding investments that can offer substantial returns. These investments can hold considerable allure for doctors because assets held within them are protected from malpractice judgments in some states.

Purchased with a large lump sum, variable annuities hold assets in mutual funds within subaccounts. They’ve been heavily marketed for the past decade as the astute investor’s answer to fixed annuities—extremely low-risk, low-return investments that don’t hold assets within mutual funds.

Variable annuities have generated less criticism than fixed annuities. Yet financially disinterested experts caution that, like fixed annuities, variable annuities fall within the broad category of investments that are sold to investors rather than sought out by them.

Brokers from financial services and insurance companies are more eager to sell variable annuities than virtually any other type of investment. The reason: By any standard, the commissions on them are whopping, and result in high buy-in costs that investors must bear. “When I was in the insurance industry, we used to joke that there was probably one lady in Iowa for whom any kind of annuity is a good product,” says Moshe Milevsky, PhD, a finance professor York University in Toronto.

As with any investment, there’s a low-cost variety that investors can seek out and purchase directly. But even with these rare birds, any asset protection that may be afforded tends to come at a price of compromised net gains. “Even low-cost annuities seldom overcome the additional expense ratio of taxes,” says William Reichenstein, PhD, CFA, a finance professor at Baylor University in Teaxs.

First, Reduce Taxable Income

Gains from securities investments held within many types of variable annuities are tax-deferred, but so are gains on securities held within retirement instruments such as an IRAs, Keoghs and simplified employee pensions (SEPs). Moreover, as do annuities, these vehicles offer protections from creditors. Yet have a key advantage that annuities lack: Contributions to them reduce the investor’s taxable income. Money that goes into annuities doesn’t. Thus, annuities must be purchased (painfully) with after-tax income.

Uninformed consumers are sometimes sold variable annuities as something to hold within an IRA. This makes no since, as these investors end up paying high fees for tax deferral that they are getting.

If a prospect is making the maximum contributions to these tax-friendly retirement accounts, then sales people often present variable annuities as a means of getting tax deferral on additional gains. While tax-friendly investments have annual contribution limits, annuities have no limit on total investment—a feature that may be attractive to physicians who may be particular concerned about lawsuits.

Yet studies show that, where investment potential is concerned, consumers are far better off investing in the markets directly. This is because it takes too long for even the lowest-cost annuities on the market—the 2% that aren’t sold by brokers—to render an investment advantage, explains Dr. Reichenstein, who has done extensive study on returns from variable annuities versus those obtained from investing directly.

Taxes & Father TimeIt all comes down to taxes. When stocks held for more than a year are sold at a profit, investors must pay Uncle Sam the long-term capital gains tax of 20%. Yet gains on annuities are taxed as ordinary income—that is, the investor’s ordinary income tax rate at the time the money is removed. So those in the top federal bracket who take gains on variable annuity subaccounts during retirement could end up paying as much as 35%.

Dr. Reichenstein has run the numbers. In his published, in-depth studies, he used retrospective hypothetical scenarios using actual market returns to test variable annuities against direct investing. The results: After-tax gains from index funds consistently outstripped those of annuity subaccounts yielding the same market returns. Indeed, in one of his studies, the after tax gains from average-cost annuities (with costs of about 2%) in stock subaccounts never equaled those of a stock index fund, even after 34 years.

Low-cost annuities (those with costs of about .38%) fared better. But not well enough to make a significant difference to many physicians old enough to have paid off their medical school loans, established or bought into their practices, substantially funded their kids’ college accounts and begun paying the maximum allowable amounts into their IRA each year. It took 24 years for the after-tax gains from low-cost annuities held in stock subaccounts to surpass those of index funds.

Variable annuities also came up short in bond-fund comparisons. In a Dr. Reichenstein study, the after-tax gains of an average-cost bond annuity never caught up to those of a bond index fund at average annual returns of four or six percent. It was only when the annuity returned 8% for 35 years that its after-tax gains exceeded those of a bond index fund.

Another disadvantage: Losses in variable annuities can’t be written off. Of course, losses would be extremely unlikely in subaccounts held for decades. But those investing directly in the markets retain the flexibility of deducting losses in years that they occur—another tax advantage of skipping variable annuities and investing directly.

Further, variable annuities have a significant downside regarding estate planning. When heirs inherent stock directly, they don’t have to pay any tax on the shares’ appreciation between the original purchase date and the date of the holder’s death. This isn’t the case with variable annuities. Heirs of the subaccounts are taxed on the deceased’s gains at the regular rate, as though these gains were ordinary income.

Avoid Their Own CookingDr. Reichenstein points out that these disadvantages are reflected in the industry players avoidance of their own product. “The sales people don’t tend to own variable annuities,” he says. “These just don’t tend to be good investments, and the salesmen know it.”

Although aware of these downsides, some physicians might still consider a low-cost variable annuity if they’re considerably risk-averse and inordinately concerned about the marauding malpractice lawyers.

First, however, they should be making the maximum contributions to equally protected, tax-friendly accounts. Then they’d be well-advised to review their malpractice coverage with their attorneys. Next, they might consider, with advice from their financial advisors and an investment-minded lawyers, a full range of investments that shield assets in the state(s) involved. These might include private homes and some types of trusts.

Only after being confronted with potential alternatives for protecting assets can physicians decide if the asset-protection of variable annuities is actually worth their relatively low after-tax returns.

Richard Bierck is a financial writer and editor who lives in Princeton, NJ.

40%Percentage of all filed US medical malpractice cases that are groundless.(Harvard University)