Should you invest in a variable annuity? While there are definite positives to using variable annuities to secure a portion of your nest egg, there are also several areas of major concern.

My Mom called me recently and asked me to look over an investment product that a local financial advisor had pitched her on. She is nearing retirement age and wants to make sure she is making the right moves. I had her e-mail me over the information packet. It was one of those variable annuities. An annuity is an insurance product that pays out consistent payments to the insured. There are two types of annuities: fixed and variable.

What Is a Fixed Annuity?

With a fixed annuity you give the insurance or investment firm a chunk of money (e.g. ,$100,000) and in return the company gives you a set monthly amount (e.g., $600) until you die. There are different sub-sets of fixed annuities where the payments end at your death, they continue on until your spouse also dies, or are for a set number of years. The amount of fixed payment you receive each month is dependent on your age. The annuity provider is gambling that they can earn a higher return on the principal than you would be able to, and also that you might die sooner rather than later. If you bought a fixed annuity today with $100,000 of your portfolio and die tomorrow, the firm gets to keep the money.

What Is a Variable Annuity?

A variable annuity has some similarities with a fixed annuity: you give the company a set chunk of your portfolio, and in return you receive payments. However, that’s where the similarities end. Variable annuities offer additional perceived benefits where you get to invest the money you hand over to the company. The firm gives you a set number of investment options.

There is usually a clause that allows your monthly payment to increase if the value of your portfolio goes up; your monthly payment won’t decrease no matter the value of the portfolio. There is also usually the added benefit that you can withdraw some or all of the money you put into the annuity in the future. If for example, you were having health issues, and needed some money for long-term care, you could take $50,000 of that $100,000 you originally invested to use for those expenses.

Inflation Protection

A big risk of annuities is you are giving up a large sum of cash today for set payments in the future. If your payments never change you run the risk of inflation taking a big bite out of your monthly income. The spending power of that $600 fixed annuity payment would slowly drop over time as the cost of goods and services increases in the economy. To combat inflation, both types of annuities usually offer an inflation protection option. While this can be very valuable, it comes with a cost. To provide inflation protection to you the firm has to generate a higher return on the money you hand over to them. They usually drop the set monthly payment to help offset this increased risk. Your $600 monthly payment might fall to $475, but over time that $475 would gradually rise with inflation.

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 investment growth, such as you get from mutual funds or stocks. Even so, while there are definite positives to using variable annuities to secure a portion of your nest egg, there are also several areas of major concern.

Variable Annuities’ High Expenses

These annuities have very high expenses. We are not just talking about your typical mutual fund expense ratios. You will run into other charges with a variable annuity. Specific examples are from the 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 really decimate your nest egg’s growth.
  • 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 seven-to-10–year time frame.
  • Mortality and risk expense: The insurance portion of your contract is a risk to the firm because it has 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 examined, 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 description, 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.  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—a major selling point of variable annuities.

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%t 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. In short, your portfolio would need to grow more than 6% to realistically grow your annual payout significantly.

It’s more likely that your portfolio will slowly decrease in value. Should you decide to pull out the funds due to poor performance, you will be tagged with a 3%-to-7% surrender fee, depending on how long you’ve been in the contract. Another thing the company doesn’t put in bold letters is down in the fine print: It says the 5% income guarantee is only for the first 10 years of the contract. After the first 10 years there “may” be an extra fee associated with guaranteeing this income further.

Tax Protection Duplication

Another problem is that many times the salesperson (who is commissioned heavily for your purchasing the product) will encourage you to roll everything into the annuity. That increases their commission. To do this he or she often touts the tax-deferred benefits of using an annuity

That is all well and good, but why should you roll your 401(k) or Traditional IRA into the annuity? These retirement accounts already offer tax-deferred savings. Double tax protection 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 the provider these questions:

  • Do you have a fiduciary duty to buyers of the annuity?
  • Which accounts were you suggesting to put into the variable annuity (rolling a 401(k), 403(b), CDs, etc.) and what sum of money in total?
  • What sales commission do you receive for selling this product?
  • What is the total expense ratio on an annual basis (insurance charges, management fees, etc.) ?
  • Walk me through several different worst-case scenarios: How would it impact me, my annuitized payouts, and my account in general?

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 retirement nest egg, lest it end up getting fried.


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