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.
i think articles like this are important bc it helps folks understand why these products are horrible. Most of the time the only information the client is receiving is propaganda from the agent. They have very little real information and thus make a bad decision. As physicians, we like to hope that other fields act in a manner with ethics similar to medicine and this just isnt the case with insurance. It is always buyer beware. There are no magical investments in this world and thus insurance as an investment no matter how you slice it will almost always result with a combination of poor returns and poor liquidity. Never buy insurance products unless the primary reason you want the product is for the insurance component.
Hi,
Nice article & I would also like to suggest that Mutual Fund Store investment advisors provide unbiased investment advice that how and Why Invest In Mutual Funds.
I find it interesting that the mutual fund store spends so much web space talking about fees and how fee-only is important but despite a full page dedicated to it including a video, the actual fees aren’t mentioned. How hard is it to post “1% of the first $500K, 0.5% of the next $500K, and 0.25% after that.” Not that hard. Perhaps they’re not posted because they’re too high. Nah, Wall Street never does that.
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Can you be more specific on which pictures?
Multiplayer versions is more exciting as in this, you’ll be able to team up or even contend with other participants to defeat the enemies. they simply need to learn that you will not be able to appease everyone of your player-base. As ever we strive to help our customers make informed decisions and understand where their r4 cards are coming from.
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He was totally right. This post truly made my day. You
cann’t imagine simply how much time I had spent for this information! Thanks!
Thanks for this article. I’m a second year IM resident. One of the “perks” of our residency program is we get a few complimentary sessions with a financial planner a year who is affiliated with northwestern mutual. He spent 2.5 hours today trying to convince me to devote 100% of my roTh IRA to a variable annuity, managed by …guess who…northwestern mutual. Related to this he wanted me to stop contributing to my 403b plan (wtf?) also, he insisted I needed a supplemental disability plan….from no other than northwestern mutual. Mind you. My hospital already provides 60% disability coverage at no cost to me.
I don’t know who was crazier…me for spending 2.5 hours listening to him or him for making these suggestions.
Sorry you’ll never get that time back.
TV-
Just a thought… not sure what field or profession you are in the hospital. But you sound like you dont have a full understanding of risk management or the basics of planning. If you are a doctor, your disability plan at most hospitals covers specifics of your disabilty from “any occupation” to “own occupation” let alone it would only cover a monthly maximum. I’m assuming you are not a doctor or you would be looking into this because you make significant income and it cost less than a percent to protect 80% of your income…common sense.
Also, lets say your employer does pay for your disability policy and your are earning $100k per year. Now you are recieving $60k or 60% of your salary per year while you are disabled…but wait…there’s more…now that your employer has paid for your benefit it is taxable to you….lets say you now fall in a 28% tax bracket with state and federal your are at $43,0000 a year….Tv can you live off of less than half your paycheck per week. Good Luck.
Be smart and listen to your financial planner and not have to worry about this stuff. if you broke stop spending money on beer.
Your comment makes me laugh and reveals that you are new on the site, so welcome.
Not only do I not drink beer, but I’m not broke, am a physician, own plenty of high quality disability insurance, and suspect my understanding of “the basics of planning” and “risk management” is better than 99.9% of the population, including many financial advisers.
Thanks for stopping by. I’ve got an About page. You might try reading it before making more comments.
FWIW, this person referred to “TV” twice in the post. The comment wasn’t directed to you. But it is obvious there is little medical familiarity from this person since TV stated “IM resident”.
Thanks for the original overall blog though, WCI! So I am your age and trying to figure this out…just stay away from annuities until ~50 and then choose SPIA? Is that the take-home pearl?
SPIAs are optional. I’d read this book before buying any annuity:
https://www.whitecoatinvestor.com/the-truth-about-buying-annuities-a-review/
After sitting down for 1.5 hours with a the “Financial Planner” at my bank after requesting that he help me open an IRA, he spends the next several minutes explaining why it’s a bad idea and that a VA is the way to go. To his credit, he correctly tells me that most VAs are terrible, but that THIS ONE is perfect for me. Basically, I take some information and I’m meeting with this guy after I’ve read a book about annuities. I’ve been burned once by the Whole Life insurance scam. I have a history of being gullible. I’m sure some VAs are a good idea, but I can’t help but be suspicious of a product that everyone agrees has several bad actors in the market.
If you have not maxed out your retirement accounts (such as an IRA) buying a VA is almost surely a bad idea for you. Never get financial advice at a bank. If you do choose to meet with this guy again, read this book first:
https://www.whitecoatinvestor.com/the-truth-about-buying-annuities-a-review/