On the surface, variable annuities (VAs) seem heaven-sent to anyone who buys mutual funds. You generally start the annuity with $10,000 or $15,000, depending on the company. That money is invested in mutual funds—subaccounts, in an annuity, speak—and accumulate tax-deferred. There’s the usual range of investment choices:
- U.S. stocks,
- international stocks,
- and a balanced stock-and-bond portfolio.
You pick your own mix and can typically switch whenever the spirit moves you. Or you can ask the company to allocate your assets for you. Your money grows tax-deferred.
The rage today is for VAs with income guarantees. You’re promised a fixed, minimum income for life, with the chance that your income might rise if the stock market does well. Put another way, you can win, but you can’t lose. Supposedly.
Why am I down on variable annuities?
- Because they cost too much, raise your taxes, deliver average long-term returns, and are often sold deceptively. Is that enough to start with? I see a niche for low-load annuities, but it’s a small one.
- A variable annuity is a mutual fund investment in an insurance wrapper. You pay extra to buy your funds this way. Diversified U.S. stock funds often charge 1 percent (and less than 0.5 percent if you buy no-loads). Most variable annuities charge 2 percent or more.
- Sales expenses and profits account for most of the extra cost. The rest is insurance. You re buying a built-in option to convert your annuity into a monthly lifetime income at some point in the future. That’s money wasted. First, you might not want to convert to a lifetime income. Second, you can use ordinary savings to buy a lifetime income any time you want. The VA cost also includes a guarantee that if you die before a certain age (say, 75), your heirs will collect at least as much money as you initially invested, minus any money you’ve already taken out. This so-called benefit, however, is seldom needed or used. Over a typical annuity holding period, it’s rare for the contract to wind up with less money than you started with years earlier.
- The extra cost of a VA lowers your investment return. You’d be more prosperous if you bought those same mutual funds outside the annuity. When you withdraw money from the annuity, it’s taxed as ordinary income. Your gains in outside funds are taxed at the low capital gains rate. What’s more, annuity holders lose their flexibility If an emergency comes up and you need to take money out, you might pay a stiff penalty. If it’s in outside mutual funds, you have access to the money all the time.
“But, inside the annuity gains are tax-deferred.”
True. But it takes 15 to 25 years for the value of the tax deferral to exceed the annuity’s extra tax and investment cost. The higher your tax bracket, the more you lose by giving up the low capital gains rate, and the worse annuities look.
“But, my heirs get a money-back guarantee if I die early.”
Yes, and you pay for it excessively. You’re depriving yourself of retirement income just in case the account shrinks in value, and you die early, and it’s important to leave the original amount to your heirs. Is that a good trade-off, when you think it through?
Annuities invested in bond funds are just as problematic as those invested in stocks.
With bonds, your tax rate is the same whether you buy the annuity or not. But the cost of the annuity depresses your returns. It might still take you 20 years to outperform a bond fund purchased outside the annuity.
But be warned: anyone with an annuity is a sitting dupe.
Within a few years, your broker or planner will probably suggest that you switch to another, “better” annuity, in a tax-free exchange. If you bite, you’ll pay another commission (although, as usual, the commission is hidden so that you won’t realize how much you’ve paid). The penalty period on withdrawals will start all over again— raising the risk that you’ll have to pay for access to your own money if you need it to pay bills.