How To Use Variable Annuities the Right Way

First things first:  variable annuities are poor investments for most people (with a few important exceptions I’ll get to in a moment).  They are usually expensive, complicated, illiquid, and hard to understand for all but the most sophisticated of investors.  Unfortunately, the target of a variable annuity sales pitch is usually a financially unsophisticated middle-class investor who is usually too busy shuttling children back and forth to soccer practice to stop and read the fine print.  Even worse, the elderly are increasingly being pitched the “advantages” of variable annuities, preying on their fears of running out of money and having to live out the rest of their lives in poverty.  Almost without exception, there is no reason anybody over the age of 60 should be buying a variable annuity at all and very few reasons somebody of any age should buy one.  If you get nothing else out of this article, understand this:  read the fine print VERY carefully and be sure to understand completely the entire life-time cost of owning a variable annuity before you sign anything.

What Is a Variable Annuity?

According to Investopedia, a variable annuity is an insurance contract that usually guarantees a minimum payout at the end of some pre-defined period, with the rest of the payout being variable depending on the performance of a managed investment portfolio.  The hook here is the word “guaranteed”.  Unsophisticated investors saving for retirement, wary of the gyrations of the stock market and fearful for their future, understandably latch onto guarantees.  They think “what do I have to lose?  If the stock market does well, I get the rewards.  If not, at least I get my money back plus a little extra”.  What’s so wrong with this?  What’s wrong with it is that variable annuities are burdened by layer after layer of fees so that even if all goes well in the best of times, you don’t stand to gain much.  And if things go poorly, you may end up with a 20 year investment that ends up growing a measely 2% per year.  That’s not going to pay the bills in your old age.

Peace of Mind is EXPENSIVE

According to Morningstar, the average Variable Annuity sub-account expense ratio is roughly 2% (including insurance policy expenses).  But that’s not all.  Most VA’s  also carry surrender charges if you try to get access to your money within a certain period of time after buying in, typically at least 5 years but it can be longer.  Surrender charges can run up to 10% of the value of your account depending on when you make your withdrawal.  But that’s not all!  Many VA’s also carry annual policy contract charges of another 0% - 0.79% per year.  But that’s not all!  Variable annuities also have some of the highest sales commissions around, which explains why they are often pushed so hard.  All together, it’s not unreasonable that you would end up paying close to 3% or 4% per year in expenses to own a VA, all for a tax benefit that probably amounts to at most 2% or 3% per year!  Quite realistically, you’d be better off just paying your taxes.

But Don’t I Get a Tax Benefit?

Another hook variable annuity salesmen use to reel you in are the fact that VA’s are usually tax-deferred, just like your 401k (also like a 401k, you will owe a 10% penalty to the IRS if you withdraw money from your qualified VA before age 59 1/2).  HOWEVER, and this is a very big however, you always pay regular income tax rates on income from a Variable Annuity, even if that income comes primarly from long-term capital gains of a stock portfolio.  Basically, you are converting capital gains that would be taxed at a maximum of 15% in a taxable account into income that can be taxed up to 35%.  That’s not exactly a great deal considering you don’t get a nice tax-deduction up-front like you do with a 401k.

So Is There ANY Reason To Ever Buy a Variable Annuity?

Yes.  There are certain situations where a VA can be the perfect investment vehicle assuming that you have:

1. Maxed out all other tax-advantaged retirement options like your 401k and Roth IRA
2. Built a taxable portfolio of low-cost, tax-efficient index mutual funds or tax-managed mutual funds
3. Carefully weighed the cost benefit of the tax deferral against the illiquidity problem and higher expense ratios inherent in variable annuities
4. Chosen the absolute cheapest VA option (Vanguard has annuity portfolios with expenses of less than 0.5% per year inclusive of all insurance and policy fees while Fidelity and T Rowe Price both offer excellent options only marginally  more expensive)
5. You are investing for retirement and are absolutely certain you won’t need these funds until you turn 59 1/2

Assuming the above five points are all true and you still have money left over to save for retirement, there are a few ways you can use variable annuities to round out your portfolio.

Taxable Bonds in a Variable Annuity vs Municipal Bonds

First off, you never want to put anything in an annuity that gets its gains primarily from long-term capital gains because of the previously-mentioned tax penalty.  This includes most stock funds, both foreign and domestic.  Bond funds, on the other hand, most definitely have a place inside a variable annuity.  Since practically all the return from a bond fund over time comes in the form of interest payments (which are taxed at regular income tax rates anyway), it makes sense to put them in a variable annuity.  Think about it:  in a taxable account, you have two choices for bonds.  You can either buy tax-free municipal bonds, which have significantly lower yields than taxable bonds, or buy taxable bonds in a tax-deferred VA.  So long as the added expense ratio of buying a bond fund inside a variable annuity is smaller than the tax advantage of owning a municipal bond fund (and with Vanguard, this is practically always true), you will almost always come out ahead owning taxable bonds inside a variable annuity due to its ability to compound at a higher rate without the drag of taxes.

REITs in a Variable Annuity

Another asset class well-suited for a variable annuity are REITs (see: Are REITs a Buy?).  REITs are publically-traded companies that invest in commercial real estate and are required by law to pay out more than 90% of their taxable earnings as dividends to shareholders every year.  Since REIT dividends are taxed at ordinary income rates and the majority of REITs’ long-term return comes from re-investing these dividends, it can make good sense to buy them inside a variable annuity in order to defer taxes as long as possible.  Again, since most of the return from these securities comes from non-qualified dividends, you aren’t subjected to a tax penalty for holding them inside a variable annuity as opposed to a regular taxable account.  Fortunately, Vanguard sells a variable annuity based on its REIT Index Fund with expenses of just 0.6% per year.

That’s All, Folks

That’s it.  Those are the only two situations I can think of where a variable annuity would be appropriate for a long-term investor.  I’m sure there are a few others I haven’t thought about, but the fact that I can only think of two to begin with says a lot about what I think of their usefullness to most investors.  Can you think of any good uses I missed?  Please leave a comment and share your wisdom with the group.

UPDATE:  I forgot to mention if you’re already stuck in an expensive variable annuity, it is possible to do what’s called a 1035 exchange to transfer it to Vanguard or another low-cost providers without any penalities from the IRS.  However, you still owe surrender penalties.  You should do the math to figure out which is cheaper: paying the surrender fees now and transferring to Vanguard or living with high expenses until the surrender fees expire.  Thanks to Consumerism Commentary’s  Get Rid of Your High-Cost Variable Annuity Easily for jogging my memory

UPDATE:  Variable annuities also have a place in some peoples’ portfolio as a way to shield assets from creditors.