Variable Annuities: What You Need to Know

Been wondering what's the deal with variable annuities? Fisher Investments breaks down their structures, costs and limitations for prospective investors.

Variable annuities are frequently sold to investors with the promise of market-like growth with less “risk.” Unfortunately, the truth is that owning one of these products is not as sure a path to a rosy retirement lifestyle as their salespeople would lead you to believe. Variable annuities are confusing, often even to the people charged with dressing them up for sale. There is a great deal of variation in the types of contracts available, as well as a bewildering array of terms and conditions attached to these products, all of which need to be looked at closely.

At Fisher Investments, we have helped many clients who have come to us with issues around these financial products, and we believe it’s important for investors to have a clear understanding of just what they entail.

Features of a Variable Annuity

Like all annuities, these are a class of insurance contracts that promise to pay you a stream of income beginning at a specific time in exchange for the premiums they receive from you. As such, variable annuities have two distinct phases:

  1. The accumulation phase: This is the period when the investor makes premium payments. These premiums can be paid either as a single lump-sum payment or as regular payments over time.
  2. The pay-out phase: This is also known as the annuitization period, during which the investor receives their promised pay-outs, usually on a monthly schedule. The length of time over which the funds are returned can vary, depending on the terms of the contract, from a few years to ongoing payments for life.

What separates variable annuities from other annuities is their variable rate of return during the accumulation period. This rate is determined by allowing the annuity owner to direct funds into various “sub-accounts” as premiums are deposited, which are then used to invest in securities. Consequently, variable annuities must be registered with the Securities and Exchange Commission (SEC) in addition to state insurance regulators.

The gains or losses from these investments determine the return. Theoretically, this arrangement allows the deposits to grow during the accumulation period, leading to a potentially larger income stream in the pay-out phase. But losses are also a possibility. We’ll discuss this more later, but it’s important to remember that not all variable annuities actually protect the investor from loss.

Risk Involved

Salespeople for variable annuities typically target retirement savers who are concerned about the possibility of an economic downturn, creating the potential risk for them to outlive their retirement assets. On the surface, this logic makes sense, as an annuity can play a role in retirement plans as a way to transfer such “longevity risk” to an insurer. However, the way a variable annuity is usually structured can make it very inefficient for this purpose relative to other types of annuities.

Annuity salespeople often mention guarantees, such as “guaranteed protection against loss” or “guaranteed payments for life.” What they frequently neglect to mention is these benefits must be purchased as “riders” (add-on provisions to a basic policy that provide additional features at an additional cost). As variable annuities typically already have annual fees of as much as 1.4%, even before these rider fees are factored in,1 such riders can create a strong headwind against your investments if you actually hope to see your deposits grow.

Also, it’s important to realize that, while these features all sound attractive, what you hear may not mean what you think. Just because you think a word means one thing doesn’t mean it’s defined in the contract’s terms and conditions the same way. The only thing that will really tell you what your annuity will provide is its contract—not what the salesperson says.

For example, riders for protection against loss usually only protect the principal you deposited—not any gains. Still, receiving something is better than nothing, right? Well, let’s look at what you’d actually get back in this scenario after you’ve owned an annuity for 10 years.

Assuming you bought your annuity with a lump sum up front and that inflation held to its historical rate of around 3%2 over this time, the amount returned to you would have lost around 23% of its original value. Even assuming your deposits are made evenly over those 10 years, inflation will still have cost you roughly 12% in total. And this doesn’t even consider what the rider may have cost you in fees over the years.

Impact of 3% Inflation on Purchasing Power
of $10,000 in Annuity over 10 Years (assuming no growth)
Annuity Bought with Lump Sum
Annuity Bought with Periodic Payments
Year 1
$ 10,000
$ 1,000
Year 2
$ 9,709
$ 1,971
Year 3
$ 9,426
$ 2,913
Year 4
$ 9,151
$ 3,829
Year 5
$ 8,885
$ 4,717
Year 6
$ 8,626
$ 5,580
Year 7
$ 8,375
$ 6,417
Year 8
$ 8,131
$ 7,230
Year 9
$ 7,894
$ 8,020
Year 10
$ 7,664
$ 8,786
Percent Lost to Inflation
23%
12%

As you can see, the reassurance you might hope to gain from a variable annuity is rarely as straightforward as you would be led to believe. The features that seem the most beneficial and popular often turn out to be underwhelming when looked at closely. Whether or not the trade-offs offered by any specific annuity make sense will depend on your individual needs and circumstances; but in our view, it’s hard to find situations where the benefits actually offered by variable annuities couldn’t be accomplished by less-expensive means.

So, to recap, remember all of the following when considering a variable annuity contract:

  • The principal is not guaranteed: Unlike some other types of annuities, the principal in variable annuities usually can be lost. Investors can protect themselves against this risk, but it typically requires the purchase of a rider—further complicating the product and adding to its fee burden.
  • Inflation: Annuity payments do not always keep pace with inflation, depending on their terms. If your costs of living rise and your income stream does not, your retirement lifestyle could be in peril as your purchasing power fades over time.
  • Inflexibility: Variable annuities are illiquid. If you need money prior to annuitization, whether for an emergency or an investment opportunity, you may not be able to withdraw funds without incurring a serious penalty.
  • Insurer insolvency: Insurance-company default rates may be low, but do you really want to place all your retirement eggs in one basket when there may be severe limitations to the coverage of your state’s guarantee fund?
  • Limited ability to pass wealth on: Ownership of the principal usually transfers to the insurer upon annuitization. Typically, then, beneficiaries receive nothing after the annuitant passes, unless they had purchased a death-benefit rider.

The Fee Burdens of Variable Annuities

Whatever the broker or salesperson says, you can be pretty sure of one thing with a variable annuity: Someone is going to be paid handsomely for selling it to you, whether as an upfront sales fee or an annual commission.

In fact, variable annuity sales commissions typically range between 5 and 7% of the total assets,3 and may be even higher. There is a compelling reason these commissions are so high: Variable annuities are a hard sell, and anyone who succeeds in selling them is making a good living with a bad product. This isn’t to say salespeople are intentionally giving investors a raw deal. With the complex nature of annuity contracts, it’s our view that many of them may not truly understand how some of these features work either.

Of course, sales fees and commissions don’t even begin to account for annual fees. These charges can be many and varied, but they generally include at least 1.4% (according to the SEC)4 simply to cover the annuity’s cost. Remember, with a variable annuity your money is likely to be invested in mutual funds, which will also charge a fee (averaging 0.63% as of 2017).5 Factor in a couple of common riders—like a Minimum Death Benefit (0.61%6) and Guaranteed Lifetime Withdrawal Benefit (1.60%7) and your fees are sitting at 4.24%. In isolation, these fees may seem only marginally expensive, but when taken as a whole and compounded over the lifetime of your variable annuity, their ability to diminish your returns can be huge.

Take our example rates above, and let’s assume you invested a modest $10,000 lump sum in an annuity that puts your money in a fund which earns an average 10% annually over 10 years. After taking out the annuity’s fees and factoring in compounding interest, you’d end up with just over $16,500 through the annuity. Purchasing that same fund directly (less the fees tied just to the annuity) would have resulted in earnings for you of just over $22,000.

Difference in Return Caused by Annuity Fees
Annuity
Direct Purchase
Difference
Year 1
$ 10,000
$ 10,000
$ -
Year 2
$ 10,576
$ 10,937
$ 361
Year 3
$ 11,185
$ 11,962
$ 777
Year 4
$ 11,829
$ 13,083
$ 1,253
Year 5
$ 12,511
$ 14,308
$ 1,798
Year 6
$ 13,231
$ 15,649
$ 2,418
Year 7
$ 13,994
$ 17,115
$ 3,122
Year 8
$ 14,800
$ 18,719
$ 3,920
Year 9
$ 15,652
$ 20,473
$ 4,821
Year 10
$ 16,554
$ 22,392
$ 5,838
Assumptions
Fund Return
Annuity Fees
Fund-Only Fees
10%
4.24%
0.63%

In this example, the annuity ends up costing over $5,000—more than 40% of the potential gains! Why not just invest directly in mutual funds? After all, there are less-complicated ways to get middling returns.

Surrender Charges for Variable Annuities

As we’ve seen, a variable annuity is not likely to greatly help your retirement plan. So, what happens if you change your mind about an annuity you own? Or even more importantly, what might happen if you need to take money out of your annuity for an unexpected expense? The unfortunate truth is that if you wish to withdraw money before annuitization (or before you’re age 59½), you are likely to incur a surrender charge.

Fisher Investments has analyzed thousands of annuities over time and have found initial-year surrender charges as high as 20%. However, a more typical surrender fee might be 7% in the first year, 6% in the second, 5% in third and so on.8 You might wonder why these surrender fees seem so punitive. The answer is simple and it's two-fold:

  1. To discourage you from doing what many annuitants do: Leave!
  2. To recover the commission that was initially paid to the broker who sold you the contract.

How Do Variable Annuities Compare With Other Investments

Unless variable annuities are purchased with protection riders, they offer essentially the same risk as a direct investment. However, they usually offer an inferior level of flexibility, liquidity, personalization and, crucially, return. If you want performance from your retirement investment vehicles, then the fees associated with variable annuities are likely to disrupt your retirement plan.

Fisher Investments’ Annuity Counselors are available to offer complimentary evaluation service for qualified investors†. We’ll analyze the annuities they own or are considering, to clarify exactly what these contracts truly provide. We also help qualified investors identify opportunities globally which may be more suitable for their portfolios than an annuity. Contact us today to schedule an appointment. In the meantime, you can browse our extensive library of guides, which are designed to aid investors in understanding annuities and other retirement-planning subjects.

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1 Source: Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html; noting 1.25% M&E Risk Charge plus .15% Administrative Fee as typical charges

2 Source: FactSet Global Financial Data as of 07/12/2017. Based on US BLS Consumer Price Index from 1926-2016 showing average 2.9%

3 Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 62.

4 Source: Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html

5 Investment Company Institute, 2017 ICI Fact Book, https://www.ici.org/pdf/2017_factbook.pdf, 89.

6 Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38, 56.

7 Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102.

8 Source: Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html;