Are you an entrepreneur? Wanna buy a variable annuity from your insurance salesman? Buyer beware. The devil is in the details.
It hasn’t happened in years. It’s like the Haley’s comet. It comes around every 76 years or so. What am I talking about? What is this phenomenon?
It’s the OMG I rolled out of bed and just had to buy a variable annuity!
Excuse me, but Justin, what is a variable annuity? It’s an insurance contract between you and an insurance company. A variable annuity is a tax deferred investment that allows you to invest in a bunch of different things. Those things include sub accounts (basically mutual funds) and products that pay a fixed rate of return. Then, usually at retirement, the annuity company pays you an income stream that is determined by how the annuity performs.
Does that ever happen? Seldom. Why? Variable annuities are products sold by insurance agents and financial advisors which pay hefty commissions. They are sold as packaged products to people like John Q Business Owner. How are they sold?
Mr. Insurance Salesman: How about we buy an investment like a variable annuity that will give you a guaranteed 6% rate of return for your life, and you pay no taxes along the way until you take it out after age 59 1/2?
Mr. John Q Business Owner: No taxes? I’m getting killed on payroll taxes and these quarterly estimated tax payments are killing me. I am SO over taxes!
Mr. Insurance Sales: That’s right. You pay the taxes when you pull it out.
Mr. John Q Business Owner: And it’s insured?
Mr. Insurance Salesman: Yes. Your original investment is insured. So if you die and your investment is below what you put in, your heirs get the original amount you put in.
Mr. John Q Business Owner: Sweet! Is there a commission to buy this?
Mr. Insurance Salesman: No. I get paid by the insurance company.
Mr. John Q Business Owner: So what are we buying? What’s inside the annuity?
Mr. Insurance Salesman: Mutual Funds. The same types you own in your trust account. There are over 25 funds we can buy, a lot to choose from.
Mr. John Q Business Owner: Sounds great. How long do I have to keep the money invested? Can I pull it out whenever?
Mr. Insurance Salesman: You can take 10% out each year, and the rest you have to keep in for 7 years. But you have to make sure that you will be over age 59 ½ so you wont have to pay a 10% penalty on any of the gains.
And so it is . . . the deal is done. Mr. Insurance Salesman places the order for the variable annuity. Mr. John Q Public gets the confirmation, and everyone is happy.
But John Q Business Owner didn’t have all of the facts – unless he read the prospectus. But does anyone actually read those things?
Here is a list of things I wish John Q Public knew at the time he bought the variable annuity.
The surrender charge of the annuity is:
Year 1 – 7%
Year 2 – 7%
Year 3 – 5%
Year 4 – 4%
Year 5 – 3%
Year 6 – 2%
Year 7 – 1%
When entrepreneurs make investments they need liquidity, access to cash. The surrender charges here are pretty big.
There are 2 fees John will pay that will erode the value of his investment. The underlying expenses of the mutual funds and the mortality expense fee for the life insurance offered by the insurance company. In many cases, the combined fee is around 2%. That is what the S&P 500 index averaged for 10 years.
When John takes money out of the variable annuity, the taxes will be paid at his ordinary income tax rate. If he just bought a mutual fund, and held it longer than a year, and then sold it, he would pay taxes at the long term capital gain rate. In most cases, this rate his lower than his ordinary income tax rate. Additionally, if John bought a bunch of index funds, they are usually tax efficient, and sometimes pay little or no capital gains.
If John is looking for tax-deferred growth, he can open up a pension plan – like a 401k, a Profit Sharing Plan, or Defined Benefit Plan. All of these retirement plans allow John to make a tax-deductible contribution. He also gets tax-deferred growth just like he could get in an annuity, usually for a cheaper cost. John can make a contribution of up to $50,000. If John has employees, he will most likely have to contribute an amount for them as well.
The guarantee of 6% is most of the time on the income of his investment, or if he annuitizes. If John decides to cash it in or sell a large chunk, John isn’t guaranteed the 6% return. He will get whatever the annuity is worth.
There is no such thing as a free lunch. Mr. Insurance Salesman get’s paid about 5.40% up front from the insurer. That’s basically from the 2% expenses that John Q is paying every year. I have no problem about insurance salesmen getting paid. I know many of them and they do good work. Insurance is a very important tool to secure your financial situation. I’m just a fan of disclosing all of the positives and negatives of a financial product.
If John Q Business Owner is looking for cash flow in retirement, he should plan on making his business saleable – and plan on selling the business. If you are still reading this – email me and let me know if you would like a list of things you can do right now to get your business ready for sale – even if you have no plans to sell your business in the foreseeable future.
Bottom line, it may make sense for John to create a diversified, tax efficient portfolio with a risk level that suits his needs.