Variable annuities (VA) are an insurance product that is best described as a mutual fund wrapped in an insurance wrapper and covered with fees.  They have several advantages over mutual funds (in a fully taxable brokerage account), including tax-deferred earnings, some protection against creditors, and tax-free buying and selling within the account.  But no reasonable person would argue that investing in a VA is a smarter move than investing in an IRA, Roth IRA, or 401K.  However, it isn’t uncommon to hear arguments that “a doctor in a high tax bracket should invest in a VA instead of in mutual funds in a taxable account.”  That argument, of course, is almost always made by someone who sells VAs for a living.

Problems With Investing in a Variable Annuity

1) Taxed at Ordinary Income Tax Rates

If the chief upside of investing in a VA is tax-deferred growth (i.e. the investment isn’t taxed each year on its capital gains and dividends), then the chief downside is that when you pull the money out it is taxed at your ordinary income tax rates rather than the lower capital gains/dividends rates a mutual fund would get.  Consider two investments with the exact same after-fee return (stop laughing and just IMAGINE for a minute), one is a mutual fund and the other a VA.  How long would it take before the benefit of the tax-deferral would make up for the lower tax rate at withdrawal?  Let’s assume a 33% tax bracket, a 15% capital gains/dividends rate, and an 8% after-expense return.

Variable Annuity- Grows at 8% per year, then at the end gains are taxed at 33%

Mutual Fund- Grows at 7.7% per year (assume 2% yield each year is taxed at 15% before being reinvested), then at the end gains are taxed at 15%.

When does the after-tax return on the VA first exceed the after-tax return on the mutual fund?  After 86 years.  What?  You don’t expect to live another 86 years?  Exactly.  Tax-deferral is valuable, but not that valuable.  Doctors, as a general rule, are paranoid about taxes because they don’t understand them very well.  This causes them to dive into “tax-shelters” that they never really needed anyway.

2) Lack of Flexibility

If I own a mutual fund in a taxable account, I can sell it any day the market is open and buy another one or just take the proceeds, pay taxes on them, and purchase a boat.  It takes far more time to surrender an annuity contract, get your money, and move on.  If you want to exchange one VA for another, you get to go see another agent, sign another contract, move the money etc.  The Etrade baby can’t swap one for another with a couple of clicks of his mouse, like he could with a mutual fund.  You can call and make changes WITHIN a variable annuity, but there’s usually a limit as to how often you can do this without paying additional fees.

3) Poor Investment Choices

Most VAs are chock-full of poor investment choices.  The “sub-accounts” (mutual-fund like investments within a variable annuity) are often poorly-performing, actively managed funds with little incentive to keep fees low.  Although you can get a variable annuity from Vanguard (in cooperation with an insurance company) or other mutual fund house with better choices, most of the VAs sold by annuity salesmen (insurance agents) are composed of inferior sub-accounts.

4) Surrender Fees

Annuities are supposed to be long-term investments.  With a fixed annuity, the insurance company takes your money and puts it into longer-term investments, like stocks and bonds, then pays you each month.  In order to allow it to do so, it needs to be able to hold on to your money for a long-term period, so to encourage you to leave the money there they instituted surrender fees.  When they started offering variable annuities, they carried the rather profitable practice over.  Surrender fees generally start at about 7%, generally decreasing by 1% a year.  Sounds like a load, no?  Would you buy a loaded mutual fund?  Of course not.  So why would you buy a loaded VA?  The company has to pay the salesman somehow don’t they?

5) Mortality and Expense Fees

Since a variable annuity is an insurance product, it has to provide some kind of an insurance function.  Usually this is a guarantee that even if you die your heirs will get the greater of the value of the account or the amount you invested in it.  This is a nearly worthless guarantee at a high price.  Let’s say you had a VA you’d put $100K into.  A typical M&E expense is 1.1%.  So if the value of the VA had decreased by 25% to $75K, and you died, your heirs would get $25K from “the policy” (plus the $75K from the annuity.)  It’s like a $25K life insurance policy.  You pay 1.1% ($1100 a year, and you’re covered for $25K or so.)  You might ask yourself at this point….how much is a $25K policy worth?  Well, for a 60 year old male, a 5 year term insurance policy goes for $249 a year.  So you’re paying over four times as much as you should.  Plus, the chances of you actually needing the policy aren’t that good.  If the account is worth MORE than you paid into it (and it darn well should be after a few years, it’s an investment after all), it doesn’t pay anything.

It’s interesting to compare a Vanguard Variable Annuity to a similar Vanguard Mutual Fund.  Keep in mind that Vanguard runs these things essentially at cost, so this likely reflects the true cost of that policy.

The ER for the Vanguard Total Stock Market Mutual Fund is 0.18%.  The total ER for the Vanguard Total Stock Market VA is 0.50%.  So Vanguard (and the associated insurance company) can do it for about 0.32%.  Why would anyone pay 1.1%, over 3 times as much?  Looks like insurance company profit to me.  I won’t even go into the other fees commonly detailed in the very fine print within the prospectus.

6) No Step-up In Basis

When you die with a mutual fund, your heirs get a step-up in basis.  That means, for tax purposes, that it’s as though they bought the mutual fund themselves on the day you died.  They can immediately sell it and owe no capital gains taxes.  When you die with a VA, all those earnings that have been deferred for years are fully taxable to your heirs, and not at the favorable capital gains rates either.  I can tell you which one I’d prefer to inherit.

7) Rebalancing Isn’t A Big Issue For Mutual Funds

Proponents of VAs frequently cite the fact that you can rebalance your portfolio without any tax consequences if you’re invested in a VA.  While that is true, the tax consequences of rebalancing can be minimized or even eliminated pretty easily.  First, you can do all your rebalancing within your IRAs, 401Ks or other tax-protected account.  Second, within a taxable account, you can use distributions of dividends and capital gains to rebalance.  Third, you can always use new contributions to rebalance.  In fact, studies show that it’s best to only rebalance every 1-3 years.  So far, after 8 years of investing, I’ve never paid taxes in order to rebalance.  I don’t anticipate EVER having to.  That might not be the same for everyone, but it is pretty easy to minimize the tax hit for most.

Also, keep in mind that it takes pretty serious market fluctuation to actually generate a need to rebalance.  Consider that you have a 50/50 stock/bond portfolio and wish to rebalance it if it gets off more than 5%.  How much more does the stock portfolio have to outperform the bond portfolio in a year for you to need to rebalance?  By about 25%.  What percentage of the time are your stock and bond returns more than an absolute 25% different?  Not very often.

8) You Shouldn’t Be Market Timing Anyway

Proponents also argue that being able to swap funds around within the VA without tax consequences is a huge advantage for an aggressive investor.  While ignoring the fact that most mutual fund investors have enough assets within tax-protected accounts to do plenty of tax-free market timing, the truth is that the less jumping around between investments, chasing performance and timing the market you do, the better your returns are likely to be.  Buying and holding a static asset allocation takes the emotions out of investing, and produces better returns over time.  You’re not Warren Buffett.  Get over it.

In short, variable annuities are for the most part an investment made to be sold, not bought.  There may be a role for one in a few, very limited circumstances, primarily for those who mistakenly bought an expensive one and wish to transfer into a less expensive one or for those with little tax-protected space who wish to invest in very tax-inefficient assets such as TIPS or REITs.  You will likely be better off not mixing insurance with investing.  Don’t be so afraid of taxes that you let the tax tail wag the investment dog.  There are far worse ways to invest than in tax-efficient asset classes within a taxable account.