We recently shared the differences between fixed and variable annuities. While there are definite positives to using an annuity to secure a portion of your nest egg, there is also some large risks involved. This is especially true with variable annuities, and that’s what we will dig into today.

Should I Invest in a Variable Annuity?

Receiving fixed income that can grow as your portfolio sounds like the best of both worlds. You get to mix a fixed annuity payment with an investment growth like mutual funds or stocks. But there are several areas of major concern:

Variable Annuity High Expenses

These annuities have very high expenses. We are not just talking about your typical mutual fund expense ratios. You will run into these fees with a variable annuity. Specific examples are from a product I reviewed:

  • Sales load: It depends on the company, but many companies charge an up-front fee to investors in order to pay the commission to the person who sold the investment. Paying unnecessary fees can kill your retirement.
  • Surrender charge: If you decide you want your initial investment into the annuity back, you pay a hefty fee. These fees start at 7% of the total and gradually decrease over a 7 to 10 year time frame.
  • Mortality and risk expense: The insurance portion of your contract is a risk to the firm because they’ve made assumptions about your life expectancy. To offset some of these risks, you are charged 1.15% annually.
  • Administration fee: Tack on an additional 0.15% annually for administrative expenses.
  • Contract fee: For the annuity I looked at there was a contract fee of $35 to get started unless you were handing over more than $100,000.
  • Investment fees: These are your typical investment expense ratios that are attached to mutual funds. These were not listed in the product’s information, though you will typically find them to run 1% to 1.5% to sit inside of an annuity.

When you factor in all the fees you are looking at easily 2.3% to 3% in fees. Which leads to our next concern…

Implausible Guarantees

This product guarantees your income at 5% of the portfolio’s balance. This is stated in big, bold letters on the documentation. It also claims that as your portfolio grows, your income goes up, but can never go down. This is a major draw to this investment. So if your $1 million investment grows to $1,050,000, your 5% “take home pay” grows from $50,000 to $52,500 and never goes down.

That is all well and good until you factor in the annual fees you run into mixed with inflation. If inflation is growing at 3% per year, your portfolio should naturally provide you with 3% more income regardless of performance, just to break-even. On top of that you now have to overcome an additional 2% to 3% in costs as well. In short, your portfolio would need to grow more than 6% to realistically grow your annual pay out significantly.

More likely is your portfolio slowly decreases in value, and if you decide to pull the funds out due to poor performance you get tagged with a 3-7% surrender fee depending on how long you’ve been in the contract. Another thing they don’t put in large bold letters is down in the fine print: it says the 5% guarantee is only for the first 10 years. After the first 10 years there “may” be an extra fee associated with guaranteeing this income further.

Tax Protection Duplication

Another problem with this product is many times the salesperson (who is commissioned heavily off of you opening an account) will encourage you to roll everythinginto the annuity. That increases their commission pay. To do this they tout the tax deferred benefits of using an annuity. That is all well and good, but what happens is you end up rolling your 401k or Traditional IRA into the annuity. You already have tax deferment thanks to using these types of accounts. You don’t need double tax protection in this manner, as it does you no good.

Questions to Ask When Buying a Variable Annuity

If you or a family member is looking at a variable annuity, be sure to ask these questions at a minimum:

  • Do you have a fiduciary duty to her?
  • What accounts were you talking with her about putting into a variable annuity (rolling a 401k, 403b, CDs, etc.) and what sum of money in total?
  • What sales commission is charged for investing in this product?
  • What is the total expense ratio on an annual basis (insurance charges, management fees, M&E, etc.)?
  • Walk me through several different worse case scenarios, and how it would impact her?

The first question will answer a lot of concerns immediately: if the person selling the investment isn’t legally required to put your interests ahead of theirs, you probably want to pass. Variable annuities may have their place in your portfolio and retirement, you just have to be extremely cautious before signing over a large chunk of your nest egg.

Photo by Ged Carroll via Flickr

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