Variable Annuities: A Costly Way to Invest

Lately, as we’ve been interviewing new clients, I’ve been seeing a lot more variable annuities in their portfolios. I find this a disappointing reality—most variable annuities are just too expensive.

Let’s begin by understanding just what a variable annuity is: an insurance product that essentially wraps traditional mutual funds inside a contract. The contract can have lots of different features, but at its most basic level it is an agreement to pay the annuity owner a lifetime income, either beginning with the purchase of the policy or at some future date. How much income is paid out over time depends on how well the underlying investments perform, on the terms of the contract, and importantly, the other ancillary costs that are included in the contract.

Variable Annuity Benefits

There are three key benefits to variable annuities. The first is that they often include some kind of death benefit, typically being at least what you’ve paid into the contract in premiums. This is helpful if the value of the underlying investments has dropped at the time of your death, and could help the contract’s beneficiary. In reality, it’s a benefit that’s rarely needed.

The second benefit is that earnings inside the annuity are tax deferred, similar to retirement accounts. This means there are no taxes due on any gains or income until funds are actually withdrawn from the annuity. The caveat here is that any gains withdrawn are taxed as ordinary income, regardless of what created the gain. With capital gains tax rates fairly low, this isn’t terribly attractive, especially over long (20 or 30 year) time horizons. Also, like retirement accounts, annuities do not receive a step up in basis at death, potentially creating significant income tax considerations for heirs.

Finally, many states offer some asset protection to annuity contracts, similar to IRAs and 401k accounts, so that they may be more difficult for creditors to access.

Variable Annuity Costs

The most common complaint about variable annuities is that their costs outweigh the benefits. Most contracts contain multiple layers of fees that may not exist in a typical advisory or brokerage account.

Subaccount Costs

The underlying investments for variable annuities are called subaccounts. They are structured very much like traditional mutual funds, and are often managed so as to match some of the most popular or well-known mutual funds. But purchasing these funds through an annuity can be expensive. Sometimes, the annuities offer share classes that are comparable to the cheapest institutional of the mutual funds, but often the expenses are considerably higher.

Mortality and Expense Fees

This is basically the cost of your annuity contract “wrapper”. These fees can run at the low end between 0.1% to 0.5% for ”no load” annuities to over 2.5% at the high end. Ostensibly, this fee compensates the insurance company for the risks it faces, including having to pay benefits to annuity owners past their expected lifespan (mortality risk). In reality, these fees also cover sales expenses like commissions.

Administration Fees

These fees cover recordkeeping and other expenses, and typically run about 0.15% per year.

Rider Premiums

These cover the cost of additional features, like guaranteed lifetime withdrawal benefits. These costs are variable, though I’ve seen riders add as much as 0.6 – 1.2% each.

One of the most common riders is some kind of an enhanced death benefit rider. This is often defined as the highest anniversary value of the annuity, though it may include a minimum guaranteed return on your premium payments, too. The challenge here is that this rider can add more than 1% to the annual cost of your annuity. It’s designed to protect the value of your investment if you are unfortunate enough to die during a market downturn, but over 20 or 30 years, this rider can cost a lot more than it would provide as an insurance benefit.

Ultimately, one of the few things over which you have significant control in investing also happens to be something which has a huge impact on your results: fees. Keeping costs down is critically important in investing, and the high costs imposed by variable annuities ultimately make them a very poor choice for long-term savings.

Are Variable Annuities Right For You?

At Blankinship & Foster we do not sell annuities, nor any commissioned investment or insurance products. Our job is to help you choose the best investments and insurance contracts to achieve your goals and objectives. In a complex world, it pays to have a fiduciary wealth management firm who is truly on your side.

About Rick Brooks

Rick Brooks, CFA®, CFP® is a partner of Blankinship & Foster LLC and is the firm’s Chief Investment Officer. He is a lead advisor, counseling clients on all aspects of personal financial management. Rick serves on several boards. He is the Chairman of the Board of Girl Scouts San Diego, and also chairs the San Diego Foundation’s Professional Advisor Council. Rick and his family live in Mission Hills. Rick enjoys spending time with his family, theater, cooking, skiing, gaming and reading.

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