Whether due to inertia, pressure from agents selling them or lack of information, many educators continue to choose variable annuities for their 403(b) plans. Unfortunately, for most 403(b) retirement plan participants, variable annuities may not represent the best investment value.
Often described as “mutual funds with an insurance wrapper,” variable annuities are touted for their tax deferral and special features.* But you should be aware that most variable annuities are loaded down with fees that negatively affect your return. Worse, if you change your mind about your variable annuity investment, surrender fees can eat up more than your investment has earned.
Here are some things to keep in mind when considering a variable annuity:
Selling point: Variable annuities are tax-deferred.
Reality: This is often explained as the most attractive feature of variable annuities. However, your 403(b) or 457 plan is already tax-deferred. You receive no additional tax advantages by holding a variable annuity in a tax-deferred account.
Selling point: Variable annuities are invested in subaccounts, which allow you to take advantage of the growth potential of the stock and bond markets.
Reality: The subaccounts are invested in mutual funds, and thus have the same risk and reward potential as mutual funds with the same investment objective. You could invest directly in mutual funds through a custodial account instead (called a 403(b)(7)). With a variable annuity, you end up paying mutual fund fees plus fees charged by the variable annuity/insurance company provider.
Selling point: Variable annuities have a death benefit, so that if you die, your beneficiary will receive a specified amount, even in some cases when your account has lost value.
Reality: The typical “mortality and expense risk” charge is 1.25% of your account value per year. That’s pretty expensive insurance, and it is only worthwhile if you die when the market is down. That's because the death benefit is usually equal to the money you put in (minus any withdrawals) or some guaranteed minimum.
Here's a simplified example: Suppose you have put $3,000 a year, for a total of $30,000, into your annuity over 10 years, but the account value dropped to $28,000 in the last year. Your beneficiary will receive $30,000. However, you have paid 1.25% each year on the value of the account, or a total of more than $2,000 in mortality and expense fees. In addition, if you have already retired and started taking distributions (annuitizing), there may not be any death benefit at all, depending on the payout option you choose.
With a mutual fund, there is no death benefit, so your beneficiaries would receive the market value of the account (in this case, $28,000 instead of $30,000). If a death benefit is important to you, look into low-cost life insurance options available through your district instead. And keep this in mind: The death benefit guarantee is only as good as the financial strength and stability of the insurance company issuing the annuity.
Selling point: A guaranteed income stream in retirement.
Reality: For many educators, this seems to offer peace of mind. However, if you invest your 403(b) or 457 contributions in mutual funds, you avoid many of the fees of variable annuities. If a guaranteed income stream is important to you, you could purchase an immediate annuity with the proceeds of your 403(b) or 457 plan when you retire, rather than lose money to excess fees while you are building your nest egg.
Fees, Fees and More Fees
You can’t escape investment fees. The average mutual fund fees and expense ratio is 1.02% a year, according to the Investment Company Institute. On the other hand, the annual fees on variable annuities usually start at 2% and go up from there, according to FINRA. And that's in addition to the fees that are charged by the mutual funds that make up your subaccounts.