Variable annuities are private financial contracts that provide income for a specified period of time, such a number of years or for life, and are tied to the investment performance of the mutual funds held in the contract. While the promise of a fixed income stream is enticing, I’ll level with you about the many downsides. In short, variable annuities are expensive, restrictive and unnecessarily complicated financial products that offset any financial benefits they claim to offer.
Caveat emptor (buyer beware). The salesperson pushing a variable annuity is largely motivated by the high commissions they will receive from selling it. I belong in the camp where if you are a financial professional, your fiduciary duty is implicit and paramount, and the client’s best interest always come first. The financial professional should never be incentivized to undermine the client’s best interests for their own gain. However, in the case of variable annuities, there couldn’t be a more egregious conflict of interest.
Reasons Not to Buy a Variable Annuity
Here is a plethora of reasons not to buy one:
- Commissions. Annuities are primarily front-end loaded, commission-based products. When a salesperson tries to sell you an annuity, don't be afraid to ask about the commission they collect by selling it to you. Annuity firms can pay out commissions of 5% or more. Reality check: for each $100,000 you plunk into the annuity, that’s $5,000 or more in commissions. Furthermore, the mutual funds held in the annuity charge commission-like fees in the form of front-end loads, back-end loads, and 12b-1 fees.
- Surrender charges. Most annuity firms charge a hefty surrender fee, usually on a seven-year scale. For example, a $100,000 investment could cost you $8,000, or 8%, in surrender charges if you take your money out in the first year. The surrender charges usually go down 1% per year until reaching 0% at the end of the surrender period.
- Fees. Additionally, there is a raft of dubious fees that may be charged by the annuity firm. This can include, but is not limited to, any of the following: asset fees, management fees, annual fees, quarterly transaction fees, withdrawal fees, rider fees, administrative fees, mortality and expense fees. With fees in aggregate costing between 2-4% annually, it’s difficult for investors to make money. At best, stated interest rate contracts (often called “guaranteed” interest rate contracts) may end up only paying out the stated rate (like 2%) because the rest is negated by fees. At worst, the fees negate any profits whatsoever. (For related reading see: Passing the Buck: The Hidden Costs of Annuities.)
- Risk. The value of a variable annuity goes up and down with the market, so growth is not assured. Consider what would happen if the annuitant were to die prematurely. If the annuity has not been annuitized, the beneficiaries receive the value of the account. Depending on investment performance, this could be significantly less than what was originally invested. Or, if the annuity has been annuitized, all payments cease, even if only one payment has been made.
- Irreversible consequences. Once you annuitize, you give up the ability to recover your lump sum or pass it on to beneficiaries. For example, if you put $250,000 into an annuity at age 60 and agree to receive a monthly income for the rest of your life, it could take 25 years to break even. It’s worth belaboring my last point as well—all payments cease at the death of the annuitant.
- Lack of liquidity. Once you put tax-deferred retirement funds into an annuity contract, you can’t access those funds until you reach age 59.5. Otherwise, you have to pay a 10% penalty for early withdrawals.
- Poor tax planning. Once you put after-tax dollars into an annuity contract, withdrawals are taxed as ordinary income rather than at more favorable long-term capital gains rates. (For related reading, see: How Are Variable Annuities Taxed?)
- Inflation. Rates are currently at historic lows, and will increase in the future. Over time, the purchasing power of fixed payments is greatly reduced by inflation.
- No socially responsible choices. Most annuities do not have any environmental, social, or governance screens that measure sustainability and ethics in regard to investments. As such, your investments may be supporting companies not aligned with your values.
- Intentional derangement. Annuity contracts appear to be complex on purpose and the salespeople who tout them appear to skimp on disclosure. If the annuitant doesn’t fully grasp the terms of the contract, then that benefits the salesperson, who likely doesn’t fully understand it either. Numerous clients have come to me with annuity contracts from other financial advisors and they can’t make heads or tails of them, and they certainly weren’t aware of all the limitations. Older retirees in particular are vulnerable to this dishonorable practice. (For related reading, see: Getting the Whole Story on Variable Annuities.)
These myriad pitfalls of variable annuities add up to a strong "do not touch with a ten-foot pole" rating.
(For more from this author, see: Deciding Between Mutual Funds and ETFs.)