Annuities (Variable)
A 401(k) Inside an Insurance Contract
My friend, a 35-year-old software engineer, had maxed out his 401(k) and Roth IRA but still wanted to invest more for retirement on a tax-deferred basis. His advisor showed him a low-cost variable annuity. It’s essentially an investment account wrapped in an insurance shell. He can choose from a menu of mutual fund-like “subaccounts” to invest in, from aggressive growth funds to conservative bond funds. All his growth is tax-deferred, just like in his 401(k). It’s a tool for tax-sensitive, high-income earners who have exhausted all other retirement account options.
Variable Annuities: Investing in the Market with Tax Deferral (and High Fees?)
The High-Octane, High-Cost Retirement Vehicle
A variable annuity is like putting a turbocharger on your retirement savings. It allows you to invest directly in the market through various subaccounts, giving you the potential for high, market-driven returns, all while the growth is tax-deferred. However, that turbocharger comes with a cost. Variable annuities are known for their multiple layers of fees—for the insurance, the administration, and the underlying funds—which can create a significant drag on your performance. It’s a trade-off: you get tax-deferred growth potential beyond your 401(k), but you have to overcome the headwind of higher fees.
The Good, The Bad, and The Ugly of Variable Annuities
A Tool with Great Potential and Great Pitfalls
The good: variable annuities offer tax-deferred market growth, a wide range of investment choices, and optional lifetime income riders. The bad: they are known for high fees that can erode your returns over time. The ugly: the complexity of the contracts and the surrender charges can trap unwary investors. My colleague bought one for the growth potential but was shocked when he realized the all-in fees were over 3% per year. A variable annuity can be a powerful tool, but you must go in with your eyes wide open to the potential downsides.
Understanding Variable Annuity Subaccounts and Investment Options
Your Personal Mutual Fund Menu
When you buy a variable annuity, you’re not just buying one thing; you’re getting access to an investment platform. Inside the annuity, there is a menu of “subaccounts,” which are essentially clones of popular mutual funds. My friend’s variable annuity offered over 80 different choices, from well-known fund families like Fidelity, Vanguard, and T. Rowe Price. He was able to build a diversified portfolio of U.S. stock, international stock, and bond subaccounts, just as he would in his regular brokerage account. You are in complete control of the investment decisions.
Variable Annuity Fees Explained: M&E, Admin, Fund Fees, Rider Costs
The Four-Headed Monster of Costs
Variable annuities are notorious for their layers of fees. First, there’s the Mortality & Expense (M&E) risk charge for the insurance component. Second, an administrative fee for account maintenance. Third, the expense ratios of the underlying investment subaccounts you choose. Fourth, and often the largest, is the annual fee for any optional riders you add, like a guaranteed income benefit. It’s not uncommon for the “all-in” cost of a variable annuity to be 2.5% to 3.5% per year, a very high hurdle for your investments to clear.
Can Variable Annuity Fees Eat Up Your Returns? Absolutely.
The Silent Killer of Your Growth
Imagine your variable annuity’s subaccounts have a great year and return 8%. That seems fantastic. But then the fees kick in. Let’s say your all-in costs—for the insurance, the funds, and an income rider—total 3%. Your net return for the year is not 8%; it’s only 5%. In a flat market year where your investments return 0%, you would actually lose 3%. Over many years, this constant drag from high fees can consume a massive portion of your potential gains, which is the biggest criticism of these products.
Variable Annuities vs. Mutual Funds in a Taxable Account: Which is Better?
A Battle of Tax Deferral vs. Lower Fees and Favorable Tax Rates
The main argument for a variable annuity over a regular brokerage account is tax deferral. However, you have to weigh that benefit against two major drawbacks. First, the annuity has much higher annual fees. Second, when you eventually withdraw your gains from the annuity, they are taxed as ordinary income, which is a higher rate than the preferential long-term capital gains rates you get in a brokerage account. For many people, the lower fees and favorable tax rates of a standard brokerage account make it a better choice, despite the tax deferral of the annuity.
Guaranteed Income Riders (GMIB/GMWB) on Variable Annuities: Are They Worth the Cost?
An Expensive Way to Create a Personal Pension
The most popular feature of modern variable annuities is the guaranteed income rider, often called a GMIB or GMWB. This rider guarantees that you can receive a certain percentage of your investment as income for life, even if the market crashes and your account value goes to zero. It’s a way to get market participation with a guaranteed income safety net. The catch? These riders are very expensive, often costing 1% to 1.5% per year, which is a huge drag on your investment returns. It’s a very costly form of pension-like insurance.
The Market Risk in Variable Annuities: Your Account Value Can Go Down
No Floor, No Ceiling
Unlike a fixed or indexed annuity, a variable annuity offers no downside protection from the market. Your cash value is directly invested in the subaccounts you choose. If the market goes up 20%, your account value goes up 20% (minus fees). But if the market crashes and drops 30%, your account value takes that 30% loss, plus fees. You are taking on full market risk. This is why variable annuities are only suitable for investors with a high risk tolerance and a long time horizon to recover from potential market downturns.
Using Variable Annuities for Long-Term Retirement Accumulation
A Tool for Maxed-Out Savers
A variable annuity can be a reasonable tool for retirement accumulation, but only after you have exhausted all other options. The proper order of operations is: first, contribute enough to your 401(k) to get the full employer match. Second, max out your Roth IRA. Third, max out the rest of your 401(k). Only after you have done all of that, and you still want to save more for retirement in a tax-deferred vehicle, should you even begin to consider a variable annuity. It’s a supplemental tool, not a foundational one.
Variable Annuity Death Benefits: Protecting Your Heirs (for a Fee)
Insurance on Your Investment
Most variable annuities come with a basic death benefit. If you invest $100,000 and the market crashes so your account is only worth $70,000 when you die, the basic death benefit guarantees your beneficiary will get back at least your original $100,000. Many also offer enhanced death benefit riders (for an extra fee) that can lock in market gains or grow by a certain percentage each year. It’s a way to ensure your heirs will receive a minimum amount, regardless of how your investments perform.
Are Variable Annuities Suitable for Conservative Investors? No.
This is a High-Risk Product
Absolutely not. A variable annuity is an investment product that is directly exposed to stock market volatility. A conservative investor’s primary goal is capital preservation. The fact that the account value in a variable annuity can decrease significantly during a market downturn makes it completely unsuitable for someone with a low risk tolerance. Conservative investors should be looking at products with principal protection, like fixed annuities, CDs, or bonds, not a market-driven product like a variable annuity.
Comparing Variable Annuity Products: Look at Fees, Investments, Riders
A Deep Dive into the Details is Non-Negotiable
When comparing variable annuities, you have to be a detective. Don’t just look at the glossy brochure. Get the prospectus. First, compare the all-in fees: the M&E charge, administrative fees, and the expense ratios of the subaccounts you plan to use. Second, look at the quality and breadth of the investment options. Do they offer low-cost funds from reputable families? Third, if you are interested in riders, compare the costs and the features of the income or death benefit riders. The lowest-fee chassis with the best investment options is usually the winner.
Understanding Variable Annuity Prospectuses: A Necessary Evil
Where All the Costs and Risks Are Buried
A variable annuity prospectus is a dense, legalistic, 100+ page document. It is intimidating, but it is the single most important tool you have. By law, the insurance company must disclose every single fee, charge, risk, and feature of the contract within that document. Reading it is a necessary evil. Pay special attention to the “Fee Table” and “Risk Factors” sections. It’s where you’ll find the unvarnished truth about the product, free from the marketing spin of a salesperson.
The Tax Treatment of Variable Annuity Withdrawals and Income
Tax-Deferred Growth, But Ordinary Income Rates on Payouts
The growth inside a variable annuity is tax-deferred, which is a great benefit. However, the taxation on withdrawal is a major drawback. When you take money out, the gains are taxed as ordinary income, at your highest marginal tax rate. This is much less favorable than the lower long-term capital gains tax rates you would get on investments held in a standard brokerage account. This tax treatment can significantly reduce your net, after-tax returns compared to a non-annuity investment.
Variable Annuities vs. Indexed Annuities: Investment Control vs. Caps/Floors
Choosing Your Risk-and-Return Engine
The choice between a variable and an indexed annuity comes down to how you want to participate in the market. With a variable annuity, you have direct control. You pick your subaccounts and receive the full market return, both positive and negative. With an indexed annuity, you give up that direct control. Your return is linked to an index but is limited by caps, and you are protected from losses by a 0% floor. A variable annuity offers more control and higher potential returns, while an indexed annuity offers more protection.
When Might a Variable Annuity Make Sense? (Maxed Out Other Retirement Accounts?)
The Final Stop on the Tax-Deferred Train
A variable annuity generally only makes sense for a small subset of high-income investors. The ideal candidate is someone who is already contributing the maximum legal amount to their 401(k)s and IRAs, and they still have additional money they want to invest for retirement in a tax-deferred manner. For this “maxed-out” investor, the tax deferral offered by a low-cost variable annuity might be valuable enough to outweigh the higher fees compared to a taxable brokerage account. It is a niche solution for a specific problem.
Surrendering Your Variable Annuity Early: Expect Penalties
The Lock-Up Period is Real and Expensive
Just like other annuities, variable annuities come with a surrender period, often lasting 7 years or more. If you need to liquidate your account during this period, you will face a stiff surrender charge. This penalty starts high, perhaps at 8% in the first year, and declines by one percent each year. This is how the insurance company recoups the high commission paid to the salesperson. You should never put money into a variable annuity that you might need to access before the surrender period is over.
Managing Your Variable Annuity Investments: Active vs. Passive
You Are the Portfolio Manager
A variable annuity is not a “set it and forget it” product. You are the portfolio manager for your subaccounts. This means you need to have an investment strategy. You must decide on an appropriate asset allocation between stock and bond funds, you should rebalance your portfolio periodically (at least once a year), and you need to monitor the performance of your chosen funds. If you are not comfortable making these ongoing investment decisions, a variable annuity is not the right product for you.
The Role of Financial Advisors in Selling Variable Annuorities (Commissions)
Be Aware of the Incentives
Variable annuities have historically paid some of the highest commissions to the financial advisors and brokers who sell them. It’s not uncommon for the commission to be 5% or more of the initial investment. This creates a potential conflict of interest, as an advisor might be motivated to recommend a variable annuity because of the large payday it provides them. This is why it is so important to understand the fees and to ask your advisor exactly how they are being compensated for the sale.
Variable Annuities and Market Timing: A Dangerous Game
Don’t Try to Outsmart the Market
Because you can switch between subaccounts inside a variable annuity, some people are tempted to try to time the market. They might move all their money to a stock fund when they think the market is going up, and then switch to a cash fund when they think it’s going to fall. This is a losing strategy. Decades of research have shown that it’s nearly impossible to time the market successfully. The best approach is to create a diversified, balanced portfolio that matches your risk tolerance and to stick with it for the long term.
How Variable Annuity Guarantees Work (and What They Cost)
Insurance on Your Investments
The “guarantees” in a variable annuity, such as a guaranteed minimum death benefit or a guaranteed lifetime income rider, are insurance features that you pay for. For example, a death benefit rider might guarantee that your heirs will receive no less than your original investment, even if the market has fallen. The income rider guarantees a future paycheck. These guarantees are provided by the insurance company in exchange for a hefty annual fee, often 1% or more, which is deducted from your account value. They are valuable, but they are not free.
Can You Do a 1035 Exchange from One Variable Annuity to Another? Yes.
A Tax-Free Transfer to a Better Product
A “1035 Exchange” is a provision in the tax code that allows you to move your money from one annuity to another without triggering a taxable event. My friend had an old, high-fee variable annuity from ten years ago. He found a new, low-cost variable annuity with better investment options. He was able to use a 1035 exchange to roll the entire account value over to the new, better annuity tax-free. This is a powerful tool for escaping a bad annuity, but you must be careful that you are not just starting a new, long surrender charge period.
Variable Annuities for High-Income Earners Seeking Tax Deferral
The “Private Pension” Strategy
For a doctor or a lawyer who is already maxing out their 401(k) and has a high income, a variable annuity can act as a sort of private pension plan. They can contribute a large, after-tax sum of money and let it grow with the market on a tax-deferred basis for many years. Then, in retirement, they can use an income rider or annuitization to turn that lump sum into a guaranteed monthly paycheck for life. It’s a way for high earners to create their own pension using a tax-advantaged investment vehicle.
What Happens to Your Variable Annuity When You Die?
Your Beneficiary Inherits the Account
If you die before you have started taking lifetime income from your variable annuity, your named beneficiary will inherit the account. They will receive the greater of the account’s current market value or any guaranteed death benefit that the policy has. The beneficiary will then have several options, including taking a lump sum, taking payments over five years, or “stretching” the payments over their own lifetime. The growth in the account will be taxable to the beneficiary as they withdraw it.
My Analysis of Variable Annuity Fees vs. Potential Benefits
The Math is Often Unfavorable
I once analyzed a popular variable annuity for a client. The all-in annual fees, including an income rider, were 3.2%. I explained to him that his investments would need to earn over 3.2% each year just for him to break even. If the market averaged 7% long-term, over 45% of his gross return would be consumed by fees. We concluded that unless the tax deferral and the income guarantee were extremely valuable to him, he would likely end up with more wealth by investing in a low-cost portfolio in a taxable account.
Questions to Ask Before Committing to a Variable Annuity
Your Anti-Regret Checklist
Before you sign a variable annuity contract, you must ask: 1) What are the total, all-in annual fees, including the M&E, admin fees, fund expenses, and rider costs? Can you show me this in writing? 2) What is the surrender charge and for how many years does it apply? 3) Are there any low-cost index fund options available as subaccounts? 4) How exactly does the income or death benefit rider work, and what is its specific cost? 5) How does this compare to just investing in a low-cost portfolio in a taxable account?
Variable Annuities: Potentially Powerful, Definitely Complex and Costly
The Final Word: Handle with Extreme Care
Variable annuities are one of the most complex and controversial products in the financial world. For a very specific type of high-income, tax-sensitive investor who has maxed out all other options, a low-cost variable annuity can be a powerful tool for tax-deferred accumulation. However, for the vast majority of people, the high fees, long surrender periods, and unfavorable tax treatment of withdrawals make them a poor choice compared to simpler, lower-cost alternatives like a 401(k), an IRA, or a standard brokerage account. Proceed with extreme caution and skepticism.
The History and Evolution of Variable Annuities
From Simple Insurance to Complex Investments
Variable annuities were created in the 1950s as a way to allow teachers to invest their pension funds in the stock market to get better, inflation-beating returns. They were a revolutionary blend of insurance and investments. Over the years, they have evolved and become much more complex, with the addition of elaborate death benefit and income riders. The industry has moved from focusing on pure accumulation to selling complex guarantees, which has also led to a significant increase in the fees and complexity of the products.
Are Newer, Low-Cost Variable Annuities Changing the Game?
A Move in the Right Direction
In response to criticism about high fees, a new generation of low-cost, “investment-only” variable annuities has emerged. These products, often sold directly by low-cost investment firms, have stripped out the expensive riders and high commissions. They offer a simple, tax-deferred investment chassis with very low insurance costs (sometimes 0.25% or less) and a menu of low-cost index funds. For the right person, these newer, leaner variable annuities can be a much more attractive and cost-effective tool for supplemental retirement savings. They are a welcome and positive evolution in the industry.
Variable Annuities: Buyer Beware, Understand the Fees and Risks
A Final Warning
The world of variable annuities is fraught with high costs, complexity, and potential conflicts of interest. While they can serve a purpose for a niche group of investors, they are often sold to people who do not understand them and for whom they are not suitable. Before you buy, you must be prepared to do a significant amount of homework. Read the prospectus, demand a full and transparent accounting of all fees, and get a second opinion from a fee-only financial advisor. This is one area of your financial life where the motto “buyer beware” is absolutely essential.