Issuers are pushing “buy backs”…plus two more costly dangers

Variable annuities combine the potential returns of stock and bond funds with a guarantee of minimum payments. With many variable-annuity contracts, those payments last for as long as the annuity owner is alive and perhaps as long as his/her spouse is alive, too. But variable annuities also are complex and confusing insurance contracts, and a single misstep could cost you or your heirs lots of money.

Three annuity mistakes to avoid…

Buyback programs could be costly. Several large insurers, including AXA Equitable and The Hartford, are offering to buy out the owners of certain variable annuities. Their offers can seem appealing—they usually exceed the annuities’ current account values by a significant margin. But only in rare circumstances should they be accepted. The annuities that insurers are trying to buy back are those issued in the late 1990s to mid-2000s, a time when interest rates were quite high. Variable annuities from that era often provide guaranteed income for life as high as 6% of the annuity’s peak value, which is much higher than any guaranteed return that you could find today.

Example: A variable-annuity issuer offers to buy back a man’s annuity for its current account value plus 20% of its original $500,000 base value. Several years of withdrawals and unusually weak investment performance have left the annuity’s current account value at just $300,000, meaning that the ­issuer is ­offering to pay $400,000 (that is $300,000 plus 20% of the original $500,000 base value). This annuity pays the man a guaranteed 6% annual return of its peak value for the rest of his life, which won’t be less than $30,000 a year, and will provide a $500,000 death benefit to the man’s heirs. If this man accepts the buyout and then uses the money to buy a comparable annuity in today’s market, he probably wouldn’t be able to do better than a guaranteed annual return of 4.5% on the $400,000 investment, which comes to just $18,000 a year. His heirs’ death benefit would shrink by $100,000.

Unfortunately, some variable-­annuity owners are being pushed to accept annuity-buyout offers by their financial advisers. These unethical advisers want to earn an additional commission by having their clients reinvest the money.

It’s worth considering selling your annuity back to the issuer only if…

A major health problem means that you are unlikely to live many more years, and the legacy you leave your heirs isn’t a high priority. An annuity’s lifetime income guarantee isn’t of great value to someone who won’t live much longer.

You need a large lump sum of cash today more than you need ­guaranteed future income or a legacy for your heirs.

You strongly believe that interest rates will shoot up very sharply in the coming year or so, to perhaps 8% or more, allowing you to earn a superior low-risk return by reinvesting this lump-sum payout. But that is very unlikely.

Estate planning could cost your spouse his/her retirement income. If you have worked with an estate-planning attorney in the years after purchasing a certain type of variable annuity, there’s a chance that the attorney made a misstep that could cost you a fortune—changing the annuity’s primary beneficiary from your spouse to a trust (or to some other heir). Even skilled estate-planning attorneys sometimes do this in hopes of avoiding estate taxes or in an attempt to pass assets to a younger generation—few attorneys are annuity experts.

The type of annuity in question is a joint-life guaranteed annuity. It is supposed to provide guaranteed income for the life of the annuity owner and his spouse. But that spousal income disappears if anyone other than the spouse is named as the primary beneficiary. This is true even if the annuity now names a trust as primary beneficiary and the spouse is the primary beneficiary of the trust. (Changing the primary beneficiary does not cause this problem if the annuity does not feature a joint-life guarantee.)

Example: A man owns a $1 million joint-life guaranteed variable annuity that is supposed to pay 6% annual income for as long as he and/or his wife are alive—a minimum of $60,000 a year. But when an estate planner advises the couple to change the annuity’s primary beneficiary to a trust, that income guarantee no longer extends to the wife. If she outlives her husband by a decade, this one mistake will cost her $600,000.

Important: If this mistake is noticed while the variable annuity’s owner still is alive, the primary beneficiary can be switched back to the spouse. If it isn’t noticed until after his death, however, nothing can be done to correct it.

Excess withdrawals could ravage your income guarantee. If you need some extra cash, you might be tempted to dip into your variable annuity—but don’t do so before investigating the consequences. Most variable annuities allow guaranteed withdrawals of perhaps 4% to 6% each year. “Excess withdrawals” above these amounts also are permitted, but the price paid for taking an excess withdrawal varies greatly depending on language buried deep in the annuity contract. Some have relatively reasonable excess-withdrawal terms. The size of the “guaranteed base” on which future annual payments are calculated might be reduced dollar for dollar by the amount of the excess withdrawal—for example, with the annuity’s death benefit reduced by the same amount. But in other annuities, taking an excess withdrawal resets the guaranteed base to its current account value, which could cost the annuity owner a tremendous amount of money.

Example: A woman’s variable annuity has a $1 million guaranteed base and a 6% annual income guarantee, but a current account value of just $500,000 when she takes a $5,000 excess withdrawal. If her annuity contract says that taking an excess withdrawal reduces her guaranteed base by the amount of the withdrawal (a reasonable rule), then in future years she would receive 6% of $995,000, reducing her future annual income by just $300, from $60,000 to $59,700. But if her contract says that an excess withdrawal resets her guaranteed base to the current account value, that $5,000 withdrawal will reduce her future annual income all the way down to $29,700. A single $5,000 withdrawal will cost her more than $30,000 every year for the rest of her life.

A Hidden Annuity Bonus

One-year certificates of deposit (CDs) recently paid less than 0.7%, on average. Money-market accounts averaged around 0.4%. Your variable annuity just might offer an ultrasafe investment option that blows those anemic returns out of the water.

Most variable annuities include what’s called a “fixed account” among their investment options. These fixed accounts provide a guaranteed annual return—exactly how large of an annual return is written into the annuity contract. If your annuity dates back to around 2008 or earlier, there’s a good chance that its fixed account has a guaranteed return of 3% or 4%, a figure that wasn’t particularly impressive back when the annuity was issued but that far exceeds any other ultrasafe investments available today.

Example: A man was about to put $300,000 into a short-term bond fund paying just 0.65% when he learned that his variable annuity had a fixed account that would pay him 3%, earning him an extra $7,000 or so per year with even less risk.

You could transfer money into this fixed account from other investments in the variable annuity or potentially put money into the annuity, if your annuity contract allows you to do so. Confirm that adding money to the annuity won’t trigger new “surrender penalties,” a charge for removing money during some designated time period after it is invested.

Alternative: If you do not invest in your variable annuity’s fixed account, you should consider investing the assets in the aggressive investments available within the annuity, such as growth stock funds. Typically, because of guarantees, your annual income and death benefits won’t fall below the amounts specified in the annuity contract even if the investments within the annuity decline sharply in value.

Take full advantage of these guarantees by purchasing aggressive investments within your annuity and less volatile investments outside of it. That is better than what many annuity owners do—they balance both risky and safe investments within their annuities and also outside their annuities.