Variable Annuities

An Effective Investment Tool for Today’s Unstable Market

By Bill De Garmo, Investment Professional

After the market downturn in 2008, many investors had found themselves in a quandary: Do I move my money to fixed accounts, and take a permanent loss? Or, do I ride out the market, and hope everything bounces back? It took a long time, but the market has finally surpassed where it was before the big downturn in 2008.

Five years ago, the strategy was to invest in “subaccounts” inside of a variable annuity with a living benefit rider.* That way, you could protect your “income base” against market loss, and still position your funds to recover if the market bounces back.

“But, Bill, isn’t it this idea passé, now that the market has come back?” Actually, no; this is an even better time to use a variable annuity as part of your investment portfolio. Let me explain.

What Is A Variable Annuity?

A variable annuity is an investment provided by an insurance company, designed for long term retirement investing. It is made up of a cluster of investments grouped into a single fund. Then, they add a layer of protection; the insurance company agrees to insure the income that the annuity will provide.

There are two components. (We don’t divide your investment into two accounts; both apply to your entire investment amount.)

a) The Contract Value. We select investments called “subaccounts”. The Contract Value is simply the value of those subaccounts, which go up and down with the market just as a stock or mutual fund does. These subaccounts are often managed by well-known firms.  As with other investments, the value of these subaccounts can fluctuate. The principle in these accounts is not guaranteed, but also has the potential for substantial gains.

b) The Income Base. This is the part that is insured. The insurance company agrees to pay you an income (often 4% to 5% per year of your Income Base) that is guaranteed until you die. The income base cannot drop in value, but can increase as your Contract Value increases. If you will not be taking income right away, then you can also add the option of a guaranteed growth of your income base (depending upon the contract), so that if the market never goes up, your income base still increases.

The Good News: If the Contract Value goes down, your Income Base is protected. AND, if the Contract Value goes up, your Income Base goes up. Most other types of investments do not provide both benefits. They do one or the other. But this method does both.

Important Note: If you decide that you need to cash out your annuity, instead of just taking an income from it, the amount you would receive is the Contract Value amount, which may be worth more or less than the total amount invested. It is important for you to understand that the Contract Value is not protected against market loss, but the Income Base is.

Two Scenarios

Here is how this plan works, no matter which way the market goes.

Scenario 1: Let’s say the market continues to rise. You may be asking yourself, “if I put my money in a variable annuity now, and then the market goes up, would I miss out?” When you move assets from your current investment into a variable annuity, the sale of those assets will lock in any gains currently experienced by that investment. In other words, you would be “selling and buying high”. You can pick investments (subaccounts) from the annuity that are in many different styles. So, if you transfer to investments in the variable annuity that are similar to your original portfolio, you can maintain your market position. That way, if the market continues to rise, and your original (now former) investments rise, your variable annuity investment will most likely also rise.

Scenario 2: What if the market drops again? Aha! In that case, the Contract Value drops, but your “Income Base” does not. Remember, the Income Base amount cannot decline. This is why now is an even better time to use this type of plan than a few years ago: You are locking in your Income Base while the market is high. Also, if you opt for the Guaranteed Income Base* (at an additional cost), you can even have a growth of either the growth rate (often 5%) or the market gain, whichever is greater.

Here is how this plan worked for one client when the market was high:  We moved his retirement account into one of these plans at the end of 2007. Fifteen months later, the country had gone through a huge market downturn, and his funds dropped from $233,000 to $137,000. The good news was that his income base had increased to $248,000. Since he had purchased the Living Benefit Rider, his future monthly income was guaranteed*: 1) to pay every year for the rest of his life, and 2) to grow until he took his first withdrawal.

Like many other investors, his account value has now barely returned to the original principal amount. However, his income base was never in jeopardy. It continued to grow each year and now exceeds his account value by more than $100,000. He will start his income withdrawals shortly, which will be 5% of the higher amount (the current income base) and is guaranteed for life.

Common Objections

There are financial people out there who do not like Variable Annuities. I would like to respond to some objections you may have already heard.

Objection 1: “But Bill, the market is doing great! How will this strategy help me now?” You’re right, but we don’t know what is going to happen in the future. This way you can position your funds to increase if the market rises, AND have a safety net if the market falls again.

Objection 2: “Someone on TV said that variable annuities only insure your money if you die.” Nope. It used to be that way, and variable annuities still have those death benefits, but currently most major carriers also offer living benefits on their variable annuities (as described on page 1).

Objection 3: “I’ve heard that annuities are expensive.” Variable annuities do have fees that are higher than mutual funds. These fees are made up of Mortality and Expense charges, fund management fees, and the fees for any riders (such as the living benefit rider). The fees are paid out of your investment funds. So, if you invested the same amount of money in both, and the funds in the mutual fund and variable annuity increased by 9% each year (for example), you would have more money over time with the mutual fund…but you would not have had any protection against potential market loss.

Objection 4: “Somebody told me that you can never get your money out of an annuity. Isn’t there a penalty for early withdrawal, or something?” Most companies let you withdraw 10% per year from the very beginning without a penalty. Over and above the 10%, there is a penalty (called a surrender charge) that applies to withdrawals occurring in the first 4 to 7 years of the policy. I usually use annuities that have the 4-year surrender charge for clients who are over the age of 50. After the surrender charge period, you can cash out the Contract Value without a penalty. Of course, if your contract value has dropped, you will not want to cash out, which leaves the insurance company on the hook to pay you from your protected income base. This is an example of the annuity-with-a-living-benefit-rider working in your favor.

Is A Variable Annuity Right For You?

Look at it like this. If you are 40 years old, and you are not going to touch your money for 20 years, it may be worth the risk to not have the protection. Historically, the market has done well when given enough time (20 years). But, if you are within a few years of needing your money, you are taking a big risk by not insuring it.

Here is my question to you: Is the fee for the protection worth the benefit?

If the volatile market has been weighing upon you, please feel free to either call or email me. I would be happy to review your specific situation to see if this strategy could help you.

Disclosure: There is a surrender charge imposed generally during the first 4 to 7 years that you own the contract. Withdrawals prior to age 59½ may result in a 10% penalty, in addition to any ordinary income tax. The sale of assets used to purchase an annuity may result in additional tax considerations which should be examined carefully. The guarantee of the annuity and any riders is backed by the financial strength of the underlying insurance company. Investment sub-account value will fluctuate with changes in market conditions. Investors should consider the investment objectives, risks and charges and expenses of the funds carefully before investing. The prospectus contains this and other information about the funds. Contact your registered representative or the fund company to obtain a prospectus which should be read carefully before investing or sending any money.

William B. De Garmo, Registered Representative of and securities offered through Cetera Advisor Networks LLC (Doing insurance business in CA as CFGAN Insurance Agency), Member FINRA/SIPC.  CA Insurance License #0624935. Registered Branch: 925-944-9644.