So, you've maxed out your annual contributions to your 401k, IRA, or other tax-deferred investment vehicle - now what? (To learn about these contribution limits, see A Tour through Retirement Plans.) There's got to be another tax-deferred investment vehicle out there, right? Well, there is. It's called a variable annuity, but buyer beware: not all annuities are created equal! Most people think of annuities simply as a steady income stream or something associated with winning your state lottery. But before you purchase one, you really need to consider all the benefits and shortfalls to determine if an annuity is really a good product for you.

What Exactly Is a Variable Annuity?

The two broad categories of annuities are immediate and tax-deferred annuities. With an immediate annuity, you make a lump-sum deposit and the insurance company guarantees an immediate monthly payment until your death. The monthly amount is based on your life expectancy. This is the type of payout option that most states offer for lottery winnings.

With a tax-deferred annuity, you invest your money and watch it grow tax-deferred until you decide to take out your money. A tax-deferred annuity can have a fixed rate, or it can be a variable product with sub-accounts. It is this increasingly popular type, which uses sub-accounts to allocate your money among mutual funds, that we are going to investigate here.

Variable annuities are commonly called "mutual funds with an insurance wrapper". In an all-in-one package sold by an insurance company, a variable annuity combines the characteristics of a fixed annuity with the benefits of owning mutual funds. Investors pay a premium to the insurance company, which then buys accumulation units under the investor's name.

The Good

Besides all the bad press that variable annuities tend to stir up from misleading sales techniques and inadequate disclosure, there are some worthy annuity products out there that are commission-free and have low expenses, no surrender charges, and are great investment vehicles.

Annuity ownership can have rewarding benefits, such as the following:

  • Tax deferral of investment gains - Just like an IRA, your contributions and earnings can grow tax-deferred until you start to withdraw funds.
  • Ease of changing investments - Because variable annuities have sub-accounts with various mutual funds to select from, it's easy to change investment direction at little or no cost to the investor.
  • Income for life - Once you select monthly payments (or annuitize) from your contract, the insurance company will guarantee you (and your spouse, should you desire) the income payment for the rest of your life.
  • Asset protection - In certain states, annuities are a shelter from creditors. If you work as a physician or in an economically hazardous occupation, they may be a great savings tool.

The Bad

Although the idea of income for life sounds great, there is one huge pitfall that most annuity salesmen forget to mention. Once you annuitize your contract, the contract is frozen - your decision is final.

Let's look at an example. Say you put $264,000 into an annuity at age 60 and accept the insurance company's offer to pay you $1,000 per month for the rest of your life. You will have to live until age 82 to break even on the contract. If you live past age 82 the insurance company must continue to pay you the monthly check, but if you die before you reach age 82 the insurance company keeps the remaining funds. So even if you die as early as age 63, the insurance company keeps the remaining balance of your $264,000. Many investors find this hard to swallow. Nevertheless, prior to selecting payout, they have to decide whether annuitizing will be beneficial - and, ultimately, this depends on how long they think they will live.

Another downside is that once you put funds into an annuity contract you cannot touch those funds until you reach age 59.5, or you pay a 10% penalty to Uncle Sam. When you do start to take funds from the contract, the portion of your payments that are considered investment gains are taxed at your ordinary income tax rate instead of the long-term capital gains rate. For some this rate could be higher than the current capital gains rate.

So you think that it can't get any worse than your funds being frozen once you select a payout option? Guess again.

The Ugly

  • Surrender charges - As if it's not bad enough that your funds are tied up until age 59.5, most insurance companies charge a surrender fee (usually on a diminishing seven- to eight-year scale), starting somewhere around 8% in the first year down to 0% in year eight. So, a $200,000 investment could cost you $14,000 (7%) in surrender fees if you exchange your annuity to another company in the second year.
  • Front-end loaded annuities - Annuities are still primarily commission-based products. When your salesperson attempts to sell you the annuity contract, don't be afraid to ask about the commission he or she collects by selling you the annuity. You can bet that if the agent is making a 5% commission on the sale, your funds will be under surrender penalty for at least five years. The mutual funds in the sub-accounts will charge fees too, so check for front-load, 12b-1 fees, and others.
  • Annual fees and administrative and mortality and expense charges - This is the area where investors get burned. These charges are buried into the cost of your annuity contract and take away from your annual profits. The average annuity will charge somewhere around 1.4% for these expenses, but some can be as high as 2.5%.


The annuity in its simplest form is a contract between you and the issuing insurance company. Annuities can be a useful place to invest some money if you've exhausted all other tax-deferred retirement plan options, but you really need to do your homework. In many cases, it may be better to buy a mutual fund outright in a taxable account. If you're invested in an annuity that's charging you annual expenses of 2% or greater, it may be time to drop that dog. There are numerous insurance companies out there feeding off of the uneducated investor by collecting surrender charges, loads, and other bogus charges. Don't let yourself be one of those victims. However, if you have your heart set on annuity investing, shop around and find the right product at the right price - and keep more of your funds where they belong: in your own wallet.

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