A Less Expensive Variable Annuity Option: IOVA
Variable annuities—for very good reasons—have bad raps. They are expensive, complex, and can be chock full of riders that benefit the insurance company more than the investor.
There are a few good reasons to own Variable Annuities (VAs), nonetheless. Though not many!
Some well-to-do investors may be maxing out tax-deferred accounts and looking for another way to tuck away after-tax money in a tax advantaged way.
Other are stuck with—or more likely sold—crappy annuities or unnecessary permanent life insurance policies and may want to consider a 1035 exchange. If you have a poorly performing life insurance policy or an expensive variable annuity, consider a tax-free 1035 exchange to an Investment Only Variable Annuity (IOVA).
IOVAs are relatively new, and although there are a handful of companies out there selling them, Vanguard, Nationwide (which bought out Jackson National), and Fidelity are the best known.
I am often distressed when I hear pod casts or read blogs discussing IOVAs. There is so much misinformation! It’s a wonder that people get any straight answers. Well, as is often the case with insurance products, it is difficult to find unbiased information.
First—let’s look at the good, bad, and ugly—when it comes to IOVAs.
The Good, Bad and, Ugly of IOVAs
This advice is NOT for Variable Annuities SOLD or PITCHED to you. It is only for IOVA’s that you want to buy. In general, Variable Annuities sold by insurance salesmen should be avoided at all costs.
The Good: Advantages
-low cost (see below)
-no surrender charges
-include tax inefficient assets such as REITs, bond funds, and actively managed funds
-1035 exchange into IOVA from a crappy product
The Bad: Drawbacks
-must be 59.5 years old or 10% penalty applies to withdrawals
-no commissions for the salesman, so no one will pitch them to you!
-limited or expensive selection of side accounts (mutual funds) to select from
-riders are difficult to understand without expert guidance (and salesman are not experts due to conflicts of interest)
-low minimum investments (Vanguard $5,000 Nationwide $15,000 Fidelity $10,000)
The Ugly: Pitfalls
-misinformation about the products
-feels sleazy using one
-confusing death benefits, if any
-kickbacks (up to 0.6% of aggregate fees at Nationwide)
I’m not sure if taxation of annuities is good, bad, or ugly!
Taxation of Investment Only Variable Annuities
Taxation of IOVAs is an important consideration. Of course, a selling point of annuities in general is that growth happens tax-deferred. Beyond that, it gets really complicated and depends on if you have annuitized the annuity or not. Annuitized means you have given up the principal and turned on the stream of cash payments that last your lifetime.
Before you have annuitized the product, you can take withdrawals (up to 6% in Vanguard) which are considered LIFO (last in first out). So, you get earnings first (taxed as ordinary income), followed by return of principal (tax-free).
Once annuitized, the payment is a combination of principal and earnings. And it depends on if you own the product in a non-qualified (after tax) or qualified (pre-tax) account.
Ok, I agree taxation is ugly with annuities.
The death benefit, if there is one, is always fully taxable. Ugly as well.
Let’s talk about the main advantage of IVOA’s next, 1035s.
1035 a Bad Product into an IOVA
As I mentioned, expensive “advisor” sold Variable Annuities or poorly performing permanent life insurance policies can be 1035 tax-free exchanged into Investment Only Variable Annuities. You get to keep your basis without tax implications. That is—if you have lost money—you can gain it back tax free. And if you have made money in a crappy product, you need not pay taxes on the gain with a 1035 exchange.
In either case—win or lose—it makes sense to get into something that suits you better. An IOVA may be just the ticket with much lower costs.
Costs of Investment Only Variable Annuity
This is where IOVAs should shine compared to VAs that are sold. Vanguard states they charge 0.5% on average whereas they quote the VA average is 2.24%. Fidelity stated 0.25% and the VA average was 1.11%.
There are annual fees. For Vanguard it is $25 unless contract has more than $25,000. For Nationwide it is $240 a year and waved if you use Nationwide funds or have the Low-Cost Fund Platform. I don’t see that Fidelity has an annual fee.
Be VERY careful with Nationwide. The reason Nationwide waves the fee for Nationwide Funds is because they are super expensive and get kickbacks! And why do they wave the fee for Low-Cost Fund Platforms?
Nationwide Low-Cost Fund Platforms
I suggest you don’t use Nationwide unless you want to use their copious yet expensive funds. There are lots of them.
If you actually want low cost, see table below for the actual cost.
Investment options inside IOVAs
Vanguard has 19 investment options. Expense Ratios (ER) range from 0.38% (total stock market) to 0.67 (growth portfolio). The average is 0.5% per Vanguard literature.
Nationwide has 364 side accounts (funds)! Talk about complexity. Expense Ratios are 0.49 (but see below for additional costs) up to >2% (in at least four funds).
Fidelity has 55 funds. Sector side accounts are around 1%. Similarly, target date and blended funds are around 0.7% to 0.9%. With the 0.25% fee added, 29/55 funds are above 1%. Only five funds have total expense less than 0.5%
Investment Only Variable Annuity Fees
Vanguard’s total fee is posted as the expense ratio for individual funds selected. Vanguard is fee transparent.
Nationwide is anything but transparent. Page 10 of the prospectus has the “optional low-cost fund platform” fees. This is an additional 0.35% fee ON TOP OF the expense ratios they provide. Of course, they wave the $20 a month fee if you use the Low-Cost Platform but otherwise hide fees. Not good Nationwide! They do offer DFA funds, Nationwide funds, and Vanguard funds with this additional 0.35% fee that is hidden on page 10 of the prospectus. So, for example, DFA funds range from 0.55% up to 0.9%.
If you don’t choose to use the Low-Cost Platform at Nationwide, there is a $20 a month charge to use their other funds. Approximately 150 funds are have <1% expense ratios, and at least 210 funds have expense ratios between 1-2%. Low cost indeed.
Fidelity says they cost 0.25%, thought they admit fund fees apply. Vanguard includes the cost in their fund fees.
Bottom Line for Investment Only Variable Annuities
This is important. Cost matters for index funds, and cost matters for IOVAs.
Actual expenses are shown above. You’d be a fool to buy the 7 listed funds equally, but if you did your Expense would be (in basis points):
Conclusion IOVA Investment-Only Variable Annuity
If you must use an variable annuity, consider an Investment-Only Variable Annuity.
Cost and complexity are the main downsides to variable annuities. At least IOVAs cost less, thought certainly they are still complex!
For the DIY, no one will sell you an IOVA. There are times when tax-deferral is indicated, especially when you need to 1035 tax-free exchange out of expensive VAs that you bought before you knew better.
There aren’t a lot of great options out there.
For cost, cost transparency, and overall fund strength, however, Vanguard wins the IOVA wars.