Investing

Variable Annuities: What They Are and Why They’re a Bad Idea for Most Investors

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I received my initial financial education, particularly as it relates to investing, courtesy of the school of hard knocks. My wife and I spent the first decade of our careers investing with an advisor, one who was paid by commissions on the products we were sold. In the process, we made many massive and expensive investing mistakes.

One investing error was especially painful. My wife quit her job and rolled over a 6 figure retirement account into a variable annuity (VA), as recommended by our trusted advisor. Years later, we began to take control of our investments and educate ourselves. We read articles explaining that VAs are very expensive and controversial products.

It was only then that we had a realization: we were sold a product that was not in our best interest, for the sake of someone else’s commission check. Now, we had to figure out what to do with it in order to move forward.

Not A Unique Experience

As I began learning and writing about investing, I became the defacto investing expert for our families. Several family members asked me to help them decipher their investments. Unfortunately, our experience was not unique. The first three portfolios I looked at all contained variable annuities, sold by different advisers from different firms.

In every case, the VA owner was shocked when I broke down all of the expenses on the products they owned. None of them were aware of the surrender fees or tax consequences incurred if they wanted to get out of these investments.

In each case, the recommendation to buy the annuity made little sense. Especially when taking into account the warnings from the U.S. Securities and Exchange Commission (SEC) or those published by the Financial Industry Regulatory Authority (FINRA) regarding VAs.

I reached out to Todd Tresidder, who wrote the book Variable Annuity Pros and Cons: Surprising Truths Your Advisor Won’t Tell You. I asked him what percentage of his coaching clients were inappropriately sold VAs. He responded, “I don’t have a percentage number that I can quote, [but] I had so many clients getting ripped off with inappropriate investments in VA products that I felt compelled to distill the principles down into that book to help them.”

Variable Annuities: The Basics

I will answer three key questions that will hopefully be all that you ever need to know about variable annuities.

  1. What is a variable annuity?
  2. Why are variable annuities generally poor investment options for most people?
  3. Why do so many people own variable annuities?

What Is a Variable Annuity?

Tresidder explains that a variable annuity is basically a mutual fund investment wrapped in the veneer of an insurance contract. Annuities have several key features that differentiate them from investing in mutual funds outside of an annuity.

Read More About Evaluating and Picking Mutual Funds

First, when it is time to take your money out of the investment, you have two options. You can take your money as a lump sum, as with any mutual fund investment. Or, if you’d rather, you have the option to annuitize this amount into a series of regular payments. The payment amount is variable, based on investment value at the time you annuitize, interest rates, and terms of the contract.

Second, VAs are taxed differently than standard mutual fund investments. Rather than being taxed at capital gains rates, the tax treatment of variable annuities is very similar to that of non-deductible, tax deferred retirement accounts. During the accumulation phase, your money accumulates without annual taxation. When taking money out as a lump sum or as an annuitized payment, any investment gains or income are taxed as ordinary income.

Third, there is an insurance component of the variable annuity. In the event that your VAs have lost value by the time of your death, they come with a benefit that typically guarantees at least the amount of your purchases. Many annuities offer other optional insurance riders at additional cost, as well.

Fourth, variable annuities lack the liquidity of mutual fund investments. Because of high sales commissions and the insurance component, most VAs have a surrender charge to exit the VA for a period of time ranging from a few years to a decade after purchasing it.

Why Are Variable Annuities Generally Poor Investment Options?

The first reason is cost. According to Vanguard, the industry average annual cost of a variable annuity is 2.24% of the assets of the fund. You can buy a diversified portfolio of low cost index mutual funds for approximately .1%. This means investing in a VA is over 20 times more expensive. This is a tremendous burden to overcome to come out ahead in the long run.

Worse than cost is the lack of value, often hidden in endless layers of complexity. Insurance guarantees against investment loss and tax advantages often sound great when presented by hard charging advisors/salesmen. However, most people do not understand what they are getting.

For example, a big sales pitch for variable annuities is the advantageous tax treatment. However, depending on your situation, there may be no tax advantage, or the taxation of the investment may actually work against you.

Variable annuities have absolutely no tax advantages if held in retirement accounts. However, advisors will often have clients roll 401(k) accounts over to these high fee products when changing jobs. This was our case and that of two of my three family members that owned VAs. Again, these were not rare occurrences. According to the National Association of Variable Annuities, fifty-five percent of all variable annuity assets are in IRA rollovers and qualified retirement accounts.

Even for taxable investments, the advantages are overstated. For tax purposes, VAs function as a non-deductible IRA. Investments are not subject to annual taxation of dividends, interest, and capital gains. However, the contributions are not deductible, and having the income and gains eventually taxed as regular income instead of generally more favorable capital gains rates can actually be a disadvantage to investing in VAs.

VAs generally are not beneficial for tax reasons unless you first max out all other investment options (401(k), IRA, HSA, etc) which have the same or better tax benefits and lower costs. Even then, further analysis is required to see if the tax benefits of a VA will be favorable enough to outweigh the costs.

Insurance is another big selling point of VAs. The sales pitch is that VAs offer the upside of mutual funds while insuring investments against loss. Again, many people do not understand what they are getting or how much they are paying for these benefits. For example, most VAs have a death benefit, at an industry average annual expense of .4% of the investment asset value. For this fee, your initial investment is guaranteed against loss.

Put this benefit into perspective. It costs approximately four times more than the all-in investment costs of simply investing in index mutual funds. It is an annual expense on your entire portfolio that will generally grow with the portfolio. Plus, it guarantees only the amount you invested, not income or gains. In order to ever benefit from the insurance, you would need to die AND at the time of your death your initial investment would have to be down in value AND your beneficiary would need the money immediately and not be able to simply wait for the investment value to recover.

Is this a worthwhile benefit for the fee? Possibly for a very select few, with very specific circumstances. Plus, I doubt the benefit and cost are explained clearly to most investors. For most of them, it is expensive and unlikely to ever be beneficial.

The death benefit is only one of the insurance options available with VA products. Others may include living benefits or stepped-up death benefits. But, as Tresidder points out, No insurance company is going to offer a feature unless they can make a profit on it.

Every bit of insurance you buy is likely a losing bet for you and a winning bet for the insurance company. This is a great reason to consider mixing insurance products with investments and to only insure the things that you can not afford to lose.

Why Do So Many People Own Variable Annuities?

The answer to this question is very simple. Advisors/salesmen are highly incentivized by high sales commissions to push these products. After all, there are high profit margins for financial institutions. According to a recent report from Senator Warren, sales are also frequently incentivized by other non-cash incentives including expensive vacations, golf outings, iPads, jewelry and other items.

All of this is done deceptively but within the letter of the law. Incentives are hidden in broad, vague language deep in hundreds of pages of long prospectuses. Cleverly worded sales pitches and advertising campaigns will claim salesmen/advisors receive no commission. The truth, though, is that their fees are built into the product in ways that are nearly impossible for consumers to decipher.

Summing Up

Variable annuities are appropriate only for a very limited group of investors in very specific circumstances. They are unnecessarily expensive and complex investment vehicles for most people.

However, they are common. This is not because they are bought by educated consumers, but because they are pushed by insurance companies for whom they are highly profitable products. For most people, this article is all you will ever need to know about VAs.

Getting out of a bad variable annuity contract is a very complicated and often expensive process. The best medicine, in this case, is certainly prevention. You should always be very careful to fully understand any investment prior to entering into it don’t just listen to the salesman’s pitch.

If you are already in a bad variable investment that you no longer want, I will provide options to get out of the contract and a framework to make the best decision while factoring in complicated factors. Look for it in an upcoming post, to be published next week.


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