Originally introduced in the 1950s, variable annuities were meant to combine the characteristics of a fixed annuity with mutual funds. The idea was that you could enjoy the benefit of an insurance-company-backed guarantee while participating directly in the equities/bond markets.
Sounds good, but not so fast. There are five important things you need to know about variable annuities:
1. Variable annuities are laden with hidden fees.
Fees, fees, and more fees. In addition to the 8% commission you usually pay right off the bat, you’ll also pay the salesperson commission every year you own the variable annuity—in addition to paying the brokerage or financial institution that the salesman works for.
When you look closely at the fine print in an actual variable annuity prospectus, you’ll see even more fees—including the insurance company fee, the separate account product fee, the mortality fee, the expense fees, and the administration fees. The mutual fund company also has its own list of administration fees buried within the contract.
If you decide to purchase the optional death benefit rider, which most people do, the fees are even higher—including account fees, guaranteed lifetime withdrawal benefit rider fees, guaranteed lifetime withdrawal benefit death rider fees, withdrawal or surrender charges and fees, and transfer fees.
There’s a fee if you keep all the funds in the investments, and there’s a fee if you move them all out. There’s a fee if you’re alive, and there’s a fee if you die. The fees on a typical variable annuity add up to around 6 or 7% every year you own it.
2. High fees mean low returns.
Right off the bat, a variable annuity prospectus admits to complex jargon. “Because of the complex nature of the variable annuity contract, we have used certain words or terms in this prospectus which may need explanation.” (Yeah, like their fees.) They go on to give a confusing example: “If you invest $10,000 in this variable annuity, after ten years, assuming you earn five percent on the funds, you would pay around 5,132 dollars minimum.” (This makes it sound like you make $5,000+.)
Here’s what the language actually means: your $10,000 after 10 years would only grow to $11,157, netting you $1,157. However, the insurance company made over $5,000.
In case you didn’t catch the math, you literally earned about 1% each year for 10 years. Keep in mind that the S&P has averaged 5.7% per year with dividends reinvested since 2000. Buying an ETF index using a robot would have beat the variable annuity net of fees—by a lot.
Even if you find a variable annuity with “lower” fees, the average annual return for these investments, without withdrawals or early surrender fees, is around 2.1%. That’s pathetic. Remember, variable annuity fees can fluctuate and get higher, and markets can drop.
3. Variable annuities are sold by salespeople, not fiduciaries.
The not-so-funny financial industry truth about variable annuities (VAs) is that they’re not bought, they’re sold. VAs are such a toxic investment that if people knew the truth, they would never buy one.
Unless your financial advisor is a true fiduciary holding a Series 65 license (not a dual license allowing them to also sell securities and not an insurance license only), they are not required to act in your best interests like fiduciaries are. They can recommend what’s “suitable” without disclosing fees.
Now, you would think since all investments are overseen by the SEC (Securities and Exchange Commission), the financial professionals who sells VAs would be held to some sort of standard. In fact, “suitability” is considered an ethical standard, but the non-fiduciary salesperson is free to recommend the product that might make them more money, without telling you that.
Furthermore, the disclosures the SEC mandates for non-fiduciary salespeople are laughable: “We do not provide any investment advice and do not recommend or endorse any particular investment portfolio. You bear the risk of any decline in the account or the account value of the contract resulting from the performance of investment portfolios you have chosen.”
The financial services salesperson with a “suitability” standard is incented to sell you a variable annuity. If you put in $100,000, he/she could get $8,000. Boom. Just like that. They are just doing their job, and their job pushes them to sell bad investments, to give bad advice, and to fulfill quotas. It’s evidently your job to not get tricked into a bad investment.
4. The investment choices inside the VA wrapper are sub-par.
Variable annuities are actually invested in the market itself. But, even if there is a bull market, like we’ve seen in the last decade, VAs still don’t perform well because the mutual funds and investment allocation options themselves are sub-par.
Many are managed funds, which almost never beat indexes, and many have fees that you won’t see on your statement at all, but that definitely hurt you. Like 12b-1 fees, considered to be an operational expense and included in a fund’s expense ratio as a percentage of net assets allowable up to 1%. There are management fees, acquired fund fees, and expenses. There’s another fee literally called “other expense fees.” (Who know what that is. Maybe it’s a fee for having to charge you fees?)
These fund fees no disclosed on your statement can add up, on average, to around 1.2%—as opposed to what a normal fund fee would be, which is 14 basis points. (One basis point is equal to 1/100th of 1%, or 0.015, or 0.0001. 14 basis points would only equal .14%.)
Here’s how Tony Robbins explains it:
“Ten to fifteen times more can be spent by one person compared to the neighbor right next door for the same fundamental product, with no additional value. You have to say “how is that possible?” Well, so much of what you pay is buried in the fine print. The language is so confusing, it almost requires a foreign language to understand. Revenue sharing, expense ratios, wrap fees, soft dollar costs, transaction costs, account charges, redemption fees, deferred sales charges. There are more than 17 total fees that can be stacked up in all that fine print.
Consider this: most plans are constructed by actively managed mutual funds. In other words, these are people, or funds, that are trying to beat the stock market. But, in the last 10 years, only 4% of all the 8,500 plus mutual funds have ever been able to beat the market, and in any 10 year period, it’s a different 4%. That means 96% of them failed, and if you look at the numbers over the last 15 years, it’s the same 96%. Different people, same ratio.”
5. You only get the guarantee when you die.
Similar to the way the house always wins in Las Vegas, with variable annuities, the insurance company always wins. Remember, variable annuities are a type of investment that allow you to actually invest in the stock market. As Investopedia likes to call it, it’s a mutual fund with an insurance wrapper. Some VA salespeople really tout the “guarantee” part of the variable annuity—saying that even if the market goes sideways, the buyer won’t lose any money.
However, the reality is, if the market goes down, you don’t have any downside protection. Your policy will hemorrhage money, and that large, lump sum may not be as big as you expected, which will be untouchable anyway because you can’t take your money out.
It’s true that you can use variable annuities, like other annuities, and get a lifetime income stream. But, let’s be very clear about how this works. If you annuitize the contract, terms are frozen.
Say you put $264,000 in annuity at age 60 and accept the insurance company’s offer to pay you $1,000 per month for the rest of your life. You will literally have to live until age 82 to break even on the contract. If you live past 82, the insurance company must continue to send you the monthly check, but if you die before you reach age 82, the insurance company keeps the remaining funds. So, if you die as early as 63, the insurance company retains the balance of your $264,000.
Other types of annuities with downside protection (or “floors” during market downturns) can have better terms, lower fees, and a much shorter timeline to break even.
Conclusion
Here’s the thing: “Sales of variable annuities are in the tank,” according to Investment News on March 31, 2018. “Product sales have slid for the past six consecutive years, and 2017 sales (roughly $96 billion) were the lowest in two decades.”
The question is, why were there any variable annuity sales at all?
