Variable Annuities: Top 5 Pros and Cons

by Rob Phillips, CPA

Variable annuities are investment contracts with an insurance company that allow you to invest your premium amount into various preapproved subaccounts.  The subaccounts are generally mutual funds that invest in stock market indexes, or in individual issues and sectors.

For investors with large premiums to invest, there are also private placement annuities that allow you to structure an investment in a specific company or in specific stocks inside of an annuity contract. Minimum investments and investor sophistication rules that vary from company to company would apply.

About Variable Annuities

Fundamentally, a variable annuity is exposed to market fluctuation.  Depending on the subaccounts that you choose, your variable annuity may go up or down with the market.  Every variable annuity has various contract provisions, guarantees, and attributes that can help mitigate risk, please see our pros and cons of variable annuities page for more information.

Variable annuities account for the majority of money flowing into the annuity marketplace in recent years.  Variable annuities are accepted by many financial advisors, but unfortunately a variable annuity dilutes the insurance aspect of an annuity contract by exposing the investor to the market risk.  It is exactly the market risk that you wish to eliminate by an annuity in the first place, so often it is hard to see the benefit of the variable annuity.

Variable Annuity Fees

Something many investors are aware of are the variable annuity fees.  An investment in a managed mutual fund inside of a variable annuity has two layers of administrative cost.  It is not uncommon for variable annuity to cost 2% or 3% of an account value every year in fees.  In our current low rate environment, making enough to counter inflation and to cover the variable annuity administrative fees is a significant return.

The reason variable annuity fees are so high, is that the insurance company that offers a variable annuity is no longer in control of the investment.  When you stay in control investment, your investment decisions represent a risk to the annuity company.  Consequently, their fees for offering these guarantees can be quite high.

 Variable Annuity Riders

Variable annuities are often bundled together with riders that add specific benefits.  These benefits often come with acronyms such as GLWB, GMIB, and GLI.  Respectively, this stands for guaranteed lifetime withdrawal benefit, guaranteed minimum income benefit, and guaranteed lifetime income.

While these riders are excellent in theory, the cost of purchasing these guarantees in a variable annuity can be quite high.

Uses of Variable Annuities

Notwithstanding, a variable annuity without the expensive riders and add-ons can be a very efficient vehicle for market investments, because your gains can increase on a tax-deferred basis over many years.  If you are an exceptional investor, and capture gains regularly, and do so in a variable annuity that does not have excessive annual fees, you can outperform similar investments in taxable accounts.

Before considering a variable annuity, assess your own needs.  Are you looking for safety, capital preservation, and moderate growth that does not fluctuate wildly with the markets? If so, should not be considering a variable annuity.

Pros And Cons of Variable Annuities

No other annuity generates as much controversy as variable annuities.  The mainstream media has a reluctant acceptance of variable annuities and can speak of the pros and cons. But individual investors often voice horror stories.  And not without reason.

Variable annuities are often sold by mainstream financial advisors, without a fundamental understanding of their purpose, and sold to investors seeking stock market participation.  The combination of the annuity costs and underlying subaccount management fees ends of creating expensive investment that does not perform well when compared to direct stock or mutual fund investments.

That said, there are various benefits to variable annuities that should be understood.

Benefits of Variable Annuities:

Depending on the contract and riders  that you choose there may be a series of benefits with your variable annuity.  Some of the contract provisions that you may come across are as follows:

  • Guaranteed death benefit- this ensures that your principle is returned to your heirs.
  • Future income benefit- this can lock in a future income stream based on an investment today.
  • Tax deferred appreciation- investment appreciation inside a variable annuity will grow tax-deferred, and not require tax payments during the course of the contract.  This can be especially useful if you have a lump sum to invest in and wish to invested in the market for a long period of time prior to withdrawal.

Cons of Variable Annuities: Cons

Variable annuities leave investors exposed to market fluctuation.  It seems that the fundamental construction of a variable annuity goes counter to what an annuity investor wants, which is safety.  Why would you buy into a product with high fees and high administrative costs that does not guarantee your principle?

Now, like any other annuity, there are many many contract provisions that can add benefits, riders,  and qualities to a variable annuity contract.  But it is hard to see these as benefits when frequently, they come with additional cost.

In addition to the costs, variable annuities often come with long surrender charges that can make accessing your money difficult if you need to.

Variable Annuity Summary

Variable annuities account for the majority of funds flowing into the annuity marketplace.  That said, it is hard to see why.  We live in a period of market turmoil, and exposure to the market is by definition a risk.

That said, if you are absolutely sure of the markets direction, and you can pick investments that only go up, and you have a variable annuity with very low cost structure, then it is a very efficient vehicle to grow your earnings tax-deferred.  If you have this sort of crystal ball, please give me a call.

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