How To Use Variable Annuities the Right Way

2008 February 27
by Kyle Bumpus
from → Annuities, Investing And Investments

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.

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14 Responses
  1. 2008 August 11
    Bob permalink

    You failed to mention the asset protection many states afford insurance/annuity products. If the investor faces possible creditor actions (physicians or other professionals who fear malpractice suits, real estate developers, etc.) investments made within an annuity may make a lot of sense. Many states, such as Florida and Texas, do not allow creditors to attach assets held within insurance policies or annuity contracts (or retirement accounts for that matter).

    Granted, it’s not a universal reason most people should invest in an annuity, but it can be an important reason for a select few.

  2. 2008 November 2
    Jeff Rose permalink

    Many of the annuity products nowadays offer what’s called and “income benefit” or “income rider” that will pay a certain amount to the beneficiary and the spouse over each of their lifetimes. Any remainder will be passed to the beneficiaries. While they could possibly get the same result in a diversified mutual fund portfolio, the simple guarantee goes a long way with some individuals.

  3. 2009 March 16
    Steve permalink

    How could you possibly write an article about the pros of variable annuities and not mention a living benefit rider, such as a GMIB or GMWB? It seems clear to me you have never actually looked at the product. A variable annuity without a living benefit is completely useless, I will agree. But the income protection provided by a GMWB rider is absolutely invaluable. Have you sat down with a spreadsheet and run the numbers? A properly designed variable annuity with a living benefit rider provides a minimum floor of 3-5%, and unlimited upside potential.

  4. 2009 March 16

    Steve, the “floor” may be 3-5% (although I don’t believe you could actually find such an annuity) but the upside is certainly not unlimited. The additional costs involved are very rarely, if ever, worth it. To answer your question yes, I’ve run the numbers. In my opinion, the GMWB is not a good option for the vast majority of investors. You can get higher income with less risk from other sources.

  5. 2009 July 31
    Mark permalink

    Thanks for these posts as quite helpful in understanding a complex product. Can you expand on your statement that “there is no reason anybody over the age of 60 should be buying a variable annuity at all”? I ask as my parents are quite sold on the idea of a variable annuity along with a living benefit rider that will guarantee them a certain minimum return/payout. I am researching this “idea” but having trouble specifying the why not to do it. They primary objective is wealth preservation and not outliving their money after having lost a chunk in the past year by being overexposed to equities. All the best, Mark

  6. 2009 September 21
    Bob permalink

    What about converting part of your IRA into a pension by shifting some into a VA? The are products now that give you a guaranteed 7% crediting rate on the highest daily value (vs quarterly or anniversary) your account ever reaches and predicates your future income payments based on that value. So while higher fees do eat into the actual account value a bit, the protection offered by locking in a guaranteed revenue stream at the investment height, helps to ensure that I am essentially monetizing the investmenst at the right time. Should have gotten in before the market went to 14,000, would love to have my annuity payments based on that level!

  7. 2010 April 6
    Mike Kent permalink

    I’m semi-retired and getting ready to withdraw from our savings. Makes sense to roll over 401K and IRAs to annuities that pay a minimum of 5% and unlimited upside. Even with fees, being protected from another drop in the market is worth a lot in retirement. Also rolled over from a previous annuity that had a floor of 3% and a ceiling (max) of 8% no matter what the market did, and with the recent rallies have already done better.

  8. 2011 August 17

    There is a reason there are so many financial products on the market; one size does not fit all investors. VA’s have a place in someone’s portfolio, living benefits play a role, mutual funds too, managed money as well, ect. But to categorically state VAs are “poor investments for most people” is not only giving improper advice but should be coached as just your opinion. This is typical stance for pundits though. I think Suze Orman says likewise. Here is an example: Jackson National VA has a living benefit for an 80 year old, which will pay her 7% for the rest of her life even if her account falls to zero. A mutual fund will not do that, no matter if it is Vanguard. JNL hase 90 variable sub-accounts with some fund expenses less than 75bps. All in she is paying 3% for: the subaccount fee, the fund expenses and the living benefit. Perhaps a tad high but there is no money manager going to guarantee a 7% payout for life. You can argue her life expectancy is short; her father lived to 96, her mother to 102. She drives and she is completely independent today at age 81. She loves the peace of mind, which you cast aside as expensive. There is no cost to having peace of mind. They are very different and should not be compared side-by-side. If there are any monies remaining (she is diversified among 16 funds: emerging markets to specialty funds to high yield bonds and AAA corporate bonds) her heirs will receive that remaining account amount. Her children are thrilled as she is no longer worrying about the market gyrations. And, last point: An annuity is nothing more than a pension. One is usually funded with employer money the annuity employee. Annuities have been around for centuries. Charles Dickens wrote about them in “Great Expectations”. Every investor is different and the lowest cost is not always the best, especially when the company’s financial’s are suffering and their ratings are below A. Thank you.

  9. 2011 August 18

    The problem is that for almost every situation where a VA might make sense, there’s another, cheaper alternative that makes MORE sense. It’s not that VA’s don’t have uses, it’s just that they are almost never the BEST use for the money. I stand by my statement in the face of your examples: the VA is not the most appropriate vehicle in those cases, either.

  10. 2012 May 21
    Joey Collura permalink

    I can show you how to add $2,000,000 to a portfolio by using VA as a strategy..starting with $1.5 and 10 years from retirement. I will crush any brokerage account with this strategy..when you are able to add that kind of money to a portfolio it doesn’t matter how much of a fee you paid to get. You need an education on Annuities before you write articles on them.

  11. 2012 May 21

    That’s less than 9% CAGR. Not particularly impressive. Does that qualify as “crushing” a brokerage account these days?

  12. 2012 June 23
    jimx388 permalink

    I think you should read a few VA prospectuses before making such blanket comments. One thing about the surrender charges is that many times the charges seem over the top however many companies provide cash bonuses during the initial investment which is reason for such high surrender charges. The actual charges over your investment basis are usually fair; of course some companies do attach very high surrender charges over basis and it would be wise to research a few of the top selling VA’s and compare each. Also, those GMIB/GMWB are usually only available to purchase at a certain age and are generally the main reason to purchase the VA because they provide a great deal of peace of mind at a very fair price. However, some investors will purchase a VA without an income benefit and it could still be a wise investment. Some companies VA’s invest using automatic shifting of portfolios during periods of market decline in order to decrease risk. Because of this, many brokerage mutual funds are outperformed by the VA, net of all fees. I would argue that VA’s are not poor investments for most people but rather a smart choice for many people to spread their risk within their overall portfolio.

  13. 2012 June 23

    I very strongly disagree. Practically everything you just mentioned can be accomplished much cheaper (resulting in higher overall returns and/or lower risk) outside of a VA. Also, the data does not support that automatically shifting portfolios during periods of market decline decreases risk. Quite the opposite. Remember the crash of 1987? It was caused by automatic shifting of portfolios during periods of market decline. Research “portfolio insurance” for data on why this is a poor investment strategy.

  14. 2013 June 4

    What’s up, yup this piece of writing is truly fastidious and I have learned lot of things from it concerning blogging. thanks.

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