The (Ugly) Math behind Variable Annuities

Variable annuities are sometimes touted as good investments, but how good are they really? A deep dive into the murky depths of an annuity contract reveals the good, the bad, and the ugly math behind these complex and often misunderstood products.

Annuities 101

An annuity is a contract between you and an insurance company. The most basic type is a fixed immediate annuity, where you pay the insurance company money up front, and you receive a contract promising to pay you a monthly income. This guaranteed income can be a for a few years (like a CD) or for the rest of your life (like a pension.)

The more complex kind of annuity is a deferred annuity, where the income payments are deferred into the future. The time before the income payments start is called the accumulation period. IRS rules allow money to grow tax-deferred while accumulating in a deferred annuity, but once your income payments start or if you take money out, the growth is taxable. The income starts when the account is annuitized—the money becomes the insurer’s, and they’ll begin making payments.


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There are three types of deferred annuities:

  • Fixed annuities promise a specific, guaranteed rate of return.
  • Indexed annuities return is based on a market index, such as the S&P 500.
  • Variable annuities return is based on the performance of a portfolio of mutual funds, or sub-accounts, that you can select from (like a 401(k).

The annuity contract

An annuity’s contract spells out all the particulars, typically spanning dozens of pages. The return during accumulation and income during annuitization are found here, as well as various definitions, stipulations, and calculations. And then there are the real complicators: the riders.

Annuity riders are agreements in the contract that provide “enhancements” such as income guarantees or death benefits. Riders can reduce investment risk and so are appealing to conservative investors. add complexity because they call for separate calculations. For example, if your contract has an income rider, your policy statement will show three different values: the accumulation (investment) value, the surrender value, and the rider value. Each has a different calculation.


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Annuity fees and expenses

There are multiple layers of fees and expenses in annuities. According to, the average total expense on a variable annuity contract is 2.3% per year and can be as high as 3%. Variable annuities also have surrender charges, which is a penalty imposed on your withdrawals if you pull money out of the contract before a certain date. Surrender charges are designed primarily to recoup the commission paid to the agent who sold the contract. These charges can last from five to ten years and can be as high as 10% in the first year of the annuity contract, declining to zero over a number of years.

In addition to these expenses, variable annuities also have the costs of the underlying subaccounts. Like the mutual funds they are typically based on, there are the annual expenses of running these investment portfolio. These charges can range from as low as about 0.6% to more than 3% annually.

Finally, there are the cost of riders. Riders can be very expensive-typically anywhere from 0.25% to 1.15% on top of the other expenses. Here is a list of the expenses found in a contract I recently reviewed:

Contract charges: 1.55%
Investment expenses: 1.04%
Rider fees:  2.80%
Total Expenses:   5.38%

It’s hard to earn much of a return when 5.38% of your investment is going to fees. Typically, the net return after fees is just one or two percent. This isn’t too attractive even if it is a guaranteed return. Over time, the investment results will typically be better by accepting some volatility and not paying all those fees.  


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Situations where annuities are helpful

As we’ve discussed, variable annuities that combine investments and other complex add-ons typically deliver sub-par results. However, there can be a use for annuities as part of your savings and investment strategy. In our practice, we often help retiring clients to consider buying an immediate annuity to replicate a pension. This adds a predictable monthly income source that lasts for as long as they do.

At Blankinship & Foster, we believe in Investing with Purpose. When the purpose for your investment portfolio includes aligning your values with your dollars, strategies such as sustainable investing can be part of your long-term investment plan. To learn more about how we can help you achieve your financial goals, contact us.

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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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