Variable Annuities

A Variable Annuity is a complex, tax-deferred retirement vehicle sold by insurance companies. Think of it as a personal pension plan you fund yourself, but with an investment twist. Unlike a fixed annuity that offers a guaranteed, modest interest rate, a variable annuity’s value fluctuates with the performance of an underlying portfolio of investments you choose, which are typically structured like mutual funds. These investment pools are called sub-accounts. The main allure is tax deferral—your investment can grow without being taxed annually. However, this shiny feature comes with a hefty price tag. Variable annuities are notorious for their layers of high fees and complex rules, which can significantly erode your returns over time. The “insurance” component often includes a death benefit, promising your beneficiaries will receive at least the amount you initially invested, even if your investments perform poorly. While sold as a retirement savings vehicle, their complexity and cost structure make them a controversial product in the investment world, especially from a value investing standpoint.

A variable annuity's life has two distinct stages: the accumulation phase and the annuitization phase.

This is the period when you are funding the annuity. You make either a single lump-sum payment or a series of payments to the insurance company. You then allocate this money among various sub-accounts, which are essentially investment portfolios of stocks, bonds, and money market instruments. Your account's value rises or falls based on the performance of these sub-accounts, minus the annuity’s considerable fees. During this phase, you, the investor, bear all the investment risk. Any earnings grow tax-deferred, meaning you don't pay taxes on the gains until you start taking withdrawals.

Once you decide to start receiving income, typically in retirement, you “annuitize” the contract. You convert the accumulated value of your account into a stream of regular payments. Here's the “variable” part: the size of these payments can fluctuate. They are tied to the ongoing performance of the sub-accounts you chose. If your investments do well, your income may increase. If they perform poorly, your income could decrease (unless you purchased an expensive rider to guarantee a minimum income). You can often choose how long the payments will last—for a specific period (e.g., 20 years) or for the rest of your life.

Variable annuities are often presented with a focus on their benefits, but a savvy investor must dig into the fine print, where the significant drawbacks are hiding.

• Tax-Deferred Growth: This is the primary selling point. You pay no taxes on investment gains until you withdraw them, allowing your money to compound more freely than it might in a taxable account.
• Potential for Market Returns: Unlike fixed-income products, you are invested in the market, giving you the potential for higher growth.
• Basic Death Benefit: Most contracts guarantee that if you die before annuitization, your beneficiary will receive at least the total amount of your contributions.

• A Fiesta of Fees: This is the product's Achilles' heel. Variable annuities are loaded with multiple layers of fees that create a massive drag on performance. It's not uncommon for total annual costs to exceed 2-3%. These include:
  • Mortality and Expense (M&E) Risk Charge: An insurance charge that typically costs around 1.25% annually.
  • Administrative Fees: Flat fees to cover record-keeping and other administrative tasks.
  • Underlying Fund Fees: Each sub-account has its own expense ratio, just like a mutual fund.
  • Fees for Riders: Optional features like a guaranteed minimum income benefit (GMIB) or enhanced death benefits come with significant additional costs.
• Tax Torpedo: This is a crucial, often misunderstood drawback. While growth is tax-deferred, all gains are taxed as ordinary income upon withdrawal. This is often a much higher rate than the preferential long-term capital gains tax rate you would pay on the same investments held in a standard brokerage account.
• Financial Handcuffs (Surrender Charges): Need your money early? Too bad. Most variable annuities impose a steep surrender charge if you withdraw funds within the first several years (often 7-10 years) of the contract. This penalty, which declines over time, effectively locks up your money.
• Complexity Overload: These products are incredibly complex. Their prospectuses can be hundreds of pages long and are notoriously difficult to understand, often obscuring the true cost and risks involved.

From a value investor’s perspective, variable annuities are generally a poor choice. The argument for tax deferral collapses under the weight of the high fees and the unfavorable ordinary income tax treatment of gains. For the vast majority of investors, a far better strategy is to:

1. First, maximize contributions to genuinely low-cost, tax-advantaged retirement accounts like a 401(k) or an IRA.
2. Second, for any additional savings, invest directly in a diversified portfolio of low-cost index funds or ETFs through a standard brokerage account.

The after-fee, after-tax returns of this simpler, more transparent approach will almost always trump a variable annuity. In essence, variable annuities are a classic case of a product that is sold by commissioned salespeople, not bought by informed investors. Avoid them. They are an expensive and complex “solution” in search of a problem that rarely exists for the prudent investor.