The Flaws of Variable Annuities

Ever walked the streets of New York City? Did you experience the snake-oil salesman luring you in with their fake Rolex watches and designer purses? Sounds familiar to the variable annuity market thanks to commissions of 5% or more.

Historically, variable annuities have gone from bust to boom. It seems as if variable annuity providers are in an "arm-race" to construct and sell the sleaziest, most deceiving product. Perfect timing uh? A 100-year event, like the market fall of 2008, can sure get people thinking differently about the complex, costly alien-like products. After all, an astonishing $33 billion in variable annuities was sold across the distribution channels in the fourth quarter of 2009. If only individuals knew what they were getting themselves into.

First, a primer. A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn't subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as "subaccounts." Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it's time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

So, what's the catch? The average expense on a variable annuity subaccount (including fund expenses and insurance costs) is typically one percent more than the average mutual fund expense ratio. Additionally, many variable annuities extract ongoing fees for administration and maintenance on the contract. An annual commission is also usually withdrawn from the account as well.

Proponents of variable annuities may point out the advantages of a death benefit. The death benefit basically guarantees that your account will hold a certain value should you die before the annuity payments begin. With basic accounts, this typically means that your beneficiary will at least receive the total amount invested — even if the account has lost money. For an added fee, this figure can be periodically "stepped-up" or earn a small amount of interest. (If you opt not to annuitize, then the death benefit typically expires at a certain age, often around 75 years old.)

Investors who bought annuities and then happened to pass away within the next two months probably got their money's worth. But considering the fact that over the long term the stock market will deliver positive returns, most folks need this insurance about as much as a duck needs a paddle to swim. While all variable annuities come with a standard death benefit, the average price for additional death benefits is 0.43%, according to Morningstar. On $1 million, if this $4,300 was used to buy a life insurance policy independent of an annuity, a healthy 50-year old man could definitely hold a policy of greater than $2 million, making the benefits of a death benefit a mute point.

Want to get your money back quickly once you invest? Tough luck. The surrender fees typically apply for 5 to 10 years. Withdrawing your funds before this time frame will result in huge fees. The surrender fees usually tier down as the years pass, but getting dinged by a 1% surrender fee in the last years can really eat into your assets. Not only that, but withdrawal before age 59 1/2 will result in a 10% penalty fee.

Gains in variable annuities are taxed at ordinary income tax rates. For most investors, that's a whole lot higher than the long-term capital gains tax rate they pay on their long-term mutual fund gains. And the tax difference can easily eat up the advantage of an annuity's tax-free compounding. Residents of some states may pay even more taxes on non-qualified variable annuity accounts. Some states also add a tax for variable annuities purchased within a qualified account, like a IRA.

Variable annuities continue to be a poor solution for a variety of factors. Some of which are not mentioned, such as estate planning issues and investment options, entailing higher expense ratios and underperfoming funds. Bottom line, ask the seller of a variable annuity how we much they will be compensated and from whom. If a conflict of interest exists, usually the solution wasn't designed with your best interests in mind.