All Variable Annuities Are Bad

Yes, all variable annuities are terrible. Every single one of them.

I have now personally reviewed a number of variable annuities held by friends and relatives of friends. I have looked in depth at the contracts, the investments, the guarantees they offer.

And they are all BAD. Bad as investments. Bad as insurance. They are the worst of all worlds.

If you find yourself considering a variable annuity (or an index-linked annuity, or variable universal life insurance, or any other thing like it), do yourself a favor and DON’T BUY IT.

If there’s one thing variable annuities are good for, it is making financial “advisors” (read: salespeople) rich. And they make you poor, not just because of higher fees but also because of tax troubles they create for you until the day you finally escape from them.

Why Are Variable Annuities So Bad?

Variable annuities are terrible because of high fees, strict penalties, and market risk. Plus they are very difficult to understand and much more expensive than “normal” low-risk investments.

Variable Annuities Have Very High Costs and Fees

High Fees: Annual expenses often total 2% to 4% or more when combining mortality and expense risks, administrative costs, subaccount management, and rider fees.

High Underlying Investment Expenses: The investments you can choose from often have very high expense ratios — often 4 to 10 times higher than what you can find commercially available.

Stack the insurance wrapper fees on top of what the underlying subaccounts charge, and it’s easy to end up paying 4% to 6% a year — before you’ve made a dime. Compare that to a plain-vanilla target date fund charging 0.08%.

Variable Annuities Have a Bunch of Penalties and Lock-Ins

Surrender charges: If you take your money out during the first 6 to 8 years, the annuity company charges a heavy fee that can start as high as 7%. Guess why they need that fee? To pay your salesperson their inflated commission! And during that time, you have no low-cost liquidity.

Clock resets: Some riders that lock in market gains — step-up or ratchet features — can reset the surrender clock every time they trigger, and additional modifications typically start a brand new surrender schedule of their own.

The worst part here is loss of liquidity. Once you sign, your money is imprisoned for a multi-year sentence. Need a large amount of cash for an emergency, a new roof, a medical bill? Too bad!

Variable Annuities Have Major Performance and Tax Drawbacks

Upside is often limited: Many variable annuities cap your potential for growth. Some annuity contracts use “participation rates” that only credit you a fraction of the market’s gain — say 70% of the S&P 500’s return — while you still absorb 100% of the downside. You’re paying market-level fees for less-than-market-level performance.

Unfavorable taxes: Earnings are taxed as ordinary income rather than lower capital gains rates. Timing withdrawals to minimize the hit takes the same kind of bracket-management math as a Roth conversion — except there’s no Roth IRA waiting on the other side to reward you for it.

No inflation adjustment: That “guaranteed” $2,000 a month looks great on the day you sign, but 20 years of even modest inflation quietly cuts its real value in half or worse.

No step-up in basis: Your heirs will hate you for having a variable annuity, because there is no step-up in cost basis when they inherit it. More than likely, this will mean dealing with taxable income in mid- to late-life, at the time they least want it.

But MY Financial Advisor Wouldn’t Sell Me Something This Bad, Would They?

Yes, they would. Variable annuities carry some of the biggest commissions in the business, up to 8% of everything you have invested.

And they can promise you anything orally. Nothing they say (or nothing you think you heard) matters, because you will eventually sign a written contract — one that will completely screw you over.

I don’t care if you met them at church, through a trusted friend, or whatever. Variable annuity salespeople are either thieves or dupes.

How Do I Escape a Variable Annuity?

If you’re already in one, don’t panic. You can eventually get out, but it takes patience and a plan.

1. Read the entire contract. Look in particular at anything with an actual number. Find the surrender schedule (it usually declines a percentage point or two each year) and the “free withdrawal” allowance. Know exactly what withdrawing costs you today versus future years, both in terms of penalties and taxes.
2. If you have low-cost investment options within the annuity, move to those. Some contracts have a few lower-fee subaccounts buried in the lineup. Shift your balance into those consistent with the risk you want to take, if you can do it without resetting your surrender periods.
3. Extract your minimum penalty-free withdrawal every year. Most contracts let you pull out 10% annually without a surrender charge. Take it. Every year you don’t is a year of unnecessary fees.
4. Consider the tax impact of withdrawals. Gains typically come out first and are taxed as ordinary income, so time your withdrawals around your other income — don’t dump it all in a high-earning year. (Your CPA can help you with this timing.)
5. Once the surrender period ends, get out. Do a 1035 exchange into a low-cost annuity if you still need the tax deferral, or cash out and reinvest normally if you don’t. It may also make sense to spread the withdrawal across a few years to minimize overall taxes.

Best Alternatives to a Variable Annuity

What you choose to do instead of a variable annuity depends on whether you thought of doing it for the security of lifetime income, or for low-risk growth. Either goal is legitimate; the variable annuity was just a poor way to get there.

Variable Annuity Alternatives for Lifetime Income

• Max out Social Security. Delaying claiming Social Security benefits to age 70 is the single best “lifetime income annuity” you can get, and it comes with inflation adjustment built in.
• Fixed simple annuity (SPIA): A single premium immediate annuity does the one thing a variable annuity claims to do — guarantee income for life — without the fee stack, the market risk, or the surrender charges.

Variable Annuity Alternatives for Conservative Growth

• A balanced portfolio with low-cost ETFs: With a simple 60% stock/40% bond portfolio, you get diversification and a shot at real returns for a fraction of a percent in fees. Want more safety? Make it 50/50 or even 40/60.
• Target date or asset allocation fund: Set it, forget it, and let the fund handle the rebalancing you were paying an “advisor” to mismanage.
• TIPS bond ladder: Guaranteed, inflation-protected income without giving an insurance company a cut.
• CDs: Boring, FDIC-insured, and exactly as safe as your annuity salesperson claimed their product was — minus the fees, the lock-in, and the commission.

Bottom line: if someone’s pitching you a variable annuity, they’re not selling you a financial plan. They’re selling themselves a commission check. Walk away.

DISCLAIMER: I am not a financial advisor and this article is not financial, legal or tax advice. This article is for educational and entertainment purposes only. All investing involves risk and your investment and other financial decisions are solely your responsibility. Past performance does not assure future results. You should do your own research and seek independent professional advice for guidance for your own personal circumstances. I am not affiliated with any of the companies or products listed, nor do I earn any compensation for the links contained here.