What is a variable annuity?

A variable annuity is an investment product offered by insurance companies. Its value depends on the performance of the underlying investment: often a mutual fund that holds stocks or bonds.

Insurance salesmen often sell variable annuities by touting it as a safe investment that also has tax-deferral and insurance benefits. But they come with significant downsides as well.

Variable annuities have features that make them bad investments for many investors. Among those downsides are huge fees and expenses relative to other investments. But variable annuities can also be difficult to liquidate without paying large fees, can appreciate more slowly due to high fees, and offer higher commissions for the salesman that can be a strong incentive to sell you a high-fee product.

You should know about these before investing in one.

How variable annuities work

You make purchase payments into the variable annuity. That money is invested into the portfolio you’ve selected: usually stocks, bonds, or fixed income. This period, where you are paying into the contract, is called accumulation.

If you want to withdraw your money during this time, the insurance company will hit you with high “surrender” penalty charges.

In the second phase, your contract “annuitizes” and (usually) pays you back the contract value. But different annuities pay you back differently. Some might offer fixed monthy payments for 10 or 20 years. Others may pay the beneficiary back for life depending on how the underlying investment performs. Others have no accumulation phase at all and begin paying out income payments immediately after you buy them.

Many varible annuities also have a death benefit in case you die when you are still paying into the annuity. In that case, the beneficiary would receive a certain amount.

Variable annuities can come with high fees and expenses

The major downside to variable annuities is their high fees and expenses. Remember, high fees directly reduce the value of your account. The fees and expenses come from money that you invest into the account, and any gains you have first must make up for those fees and expenses before you see any growth at all.

The fees charged by variable annuities can include:

M&E charge – the mortality risk and expense charge, which may exceed 1% of your account value annually

Administrative fees – annual service fees that are sometimes up to .30% of your account

Sales load/charges – incurred when you change the underlying investment (going from stocks to bonds, for example

Subaccount expenses – investment advisory fees for choosing the various investment subaccounts that may be up to 2% annually

Insurance rider expenses – a fee you pay for the Guaranteed Lifetime Withdrawal Benefit, for example

Surrender charges – these are for terminating the variable annuity contract early.

Transfer charges – you may also be charged for transferring money from one investment option to another during the accumulation phase.

When all is said and done, you may be looking at over 3% of your account value in fees every year. Consider that if you invested $100,000 in a variable annuity, fees for just for that year alone will be $3,000. Your investment gains would have to make up that $3,000 in the market just to break even, before any growth at all.  

Fees that high can mean that your investment is structured to lose from the outset.

The bottom line on the fees and expenses: they add up quickly, and can take a lot of money out of your account. In an era when inexpensive index funds exist, you have a lot of other–cheaper–options.

For example, one popular mutual fund that tracks the S&P 500 (FXAIX) has fees and expenses of just .015% per year. That means that your same $100,000 invested in an S&P 500 mutual fund would incur just 15 dollars in annual fees–a huge difference from the $3,000 you could pay for a variable annuity.

The difference between that $15 and $3,000 over a ten-year period is nearly $30,000. And that is before accounting for growth in the S&P 500 or compounding interest in your account. So if you are looking for investment gains in a variable annuity, you may want to look elsewhere.

Some annuities offer high commissions for the salesmen.

Sometimes you’ll hear “don’t worry, the insurance company pays my commission.” That may be technically true, but misleading. The insurance company pays the salesman’s commission out of money that you have paid for the variable annuity. The size of the salesman’s commission directly reduces the amount you have left over to invest in the annuity.

These commissions might range from 1%-10% of the total value of your variable annuity. But even commissions on the lower end of that are significant in the era of super-low-cost index funds.

It can be costly just to get out of the investment.

Change your mind on the variable annuity after buying it and want to cancel? Substantial “surrender” penalty charges may apply if you withdraw from the contract early. This period during which you cannot remove your money without paying this penalty can be lengthy too: six or more years.

The surrender charge is often a percentage of the amount you have invested. For example, if you change your mind about your variable annuity in the first year, the insurance company may assess you a 10% penalty to withdraw your money and cancel the contract.

Other purported benefits of variable annuities may not be all that beneficial

Some benefits of variable annuities can be realized in other financial products better. Insurance salesmen often tout the insurance benefits of variable annuities. But if it is insurance you want, you can often find cheaper insurance by simply buying a long-term care insurance policy.

Salesmen might also claim that variable annuities have tax benefits. But they can also come with higher taxes. For example, you might use after-tax dollars to buy and hold an investment for over a year. You’d benefit from lower capital gains rates when selling that investment. But if your variable annuity pays out income every year, that is taxed at higher, ordinary income rates.

This can cost you significant dollars in extra taxes down the road.

Read the prospectus

Don’t just rely on the recommendation of your financial advisor when it comes to variable annuities. Read the annuity’s prospectuses as well. See what they say about the fund’s risk, objectives, and fees and expenses.

Check out the SEC’s Guide to Variable Annuities

Also be sure to check out the Securities and Exchange Commission’s Guide to Variable Annuities. It has a lot of helpful information if you want to dive into the details.

Contact us

If you believe that a variable annuity was misrepresented to you, contact Wilkowski Law to see if we can help with your situation. Initial consultations are always free. And if we take your case, you won’t pay anything unless we recover for you.