Variable Annuities Part 1.-The Worst Life Insurance Ever!
Back in the 1970's the NYSE traded 16-20 million shares per day (vs 4 billion today), certified financial planners were a new specialty, bonds represented at least 30% of every portfolio, traded options and derivatives were becoming fully realized, tax brackets reached 70% and most importantly, defined benefit plans were being fully supplanted by defined contribution plans putting trillions of dollars under the control of individuals. Mutual funds exploded onto the financial scene and management companies sponsoring funds began to see assets under management balloon.
In this relatively high tax environment, high net worth individuals were limited in their contributions to retirement accounts and in addition to municipal bonds were looking for tax deferral and tax advantaged investments. The Variable Annuity (VA)was the Insurance Industry's answer to that tax problem and a solution to its entry into the burgeoning mutual fund market for high net worth individuals seeking tax deferral and willing to pay the price. The likelihood is that if you are reading this you do not fit that description.
Variable Annuities are Insurance Products and as such must include an insurance component, a life policy pegged to the value of the contribution. On average, VAs charge 1.35% of the portfolio value each year to pay for the insurance policy. The charge is called a "mortality" expense. On a $ 1 million dollar VA, the mortality is, $13,500/year. This amount could increase if the portfolio appreciates under provisions of most VA policies called Step-up. But what is the investor paying for?
Assume the investor dies after 10 years, having paid at $135,000 in mortality expense over that time and disregarding the impact of that expense on portfolio growth. If the investor died during a severe recession and his portfolio declined to $700,000, the investor's heirs would elect the $1 million insurance proceeds but in doing so, the insurance company keeps the $700,000 portfolio bringing the total cost to the investor/heirs to $835,000 for $1 million payout, a net benefit of $165,000.
If death occurs after 15 years there is no net benefit at all and mortality expense will exceed the benefit The amount insured is at most only the difference between the the $700k portfolio at death and the $1 million insurance amount or $300,000 less premiums paid. By comparison, a $300,000 term policy on a 50 year old male is less than $3000/year and the heirs in addition to policy proceeds get to keep the portfolio giving the heirs $1 million protection for a savings of $105,000.
If at death the VA portfolio has appreciated the heirs would inherit the portfolio but there are no insurance proceeds at all, not even a refund of premiums! So even after 10 years and $135,000 in mortality expense and death occurs there is no policy payout if the portfolio is at parity with or exceeds the insurance contract amount. The irony for many investors is that as markets rise, many pay for a premium rider to increase the insurance contract amount st additional premium for zero additional coverage. Of course had the investor bought the $300,000 term policy referenced above, the estate would have saved $105,000 in mortality expense and could have received the $300,000 policy proceeds in addition to the portfolio.
The reality of VA life insurance is that it is no more than a prohibitively expensive form of portfolio insurance intended to protect the insurance company in the event the investor dies during a recession, and to provide a windfall premium in the event the policy has to pay out. Who would pay for a life insurance policy that was unlikely to ever pay proceeds when death occurs? Variable Annuity owners.