The Pros and Cons of Variable Annuities: Look Before You Leap

If you’ve worked with a broker or financial advisor on your retirement plans, you may have heard about variable annuities. Variable annuities are common financial products brokers and insurers sell. Salespeople usually present variable annuities in glowing terms—how returns are “guaranteed,” or how your investments can grow sheltered from the taxes typically associated with securities trading. They are also purported to provide market-like growth. A product that offers tax benefits (similar to those of a qualified retirement plan) plus the freedom to invest in the market may sound appealing. However, variable annuities are complex and we believe other types of investments can offer the same or better results, often at a lower price and with fewer restrictions.

Just as you wouldn’t dive into a swimming pool before checking the depth, you should not plunge headlong into a variable annuity without first understanding the risks. Depending on your needs, variable annuities may be useful, but, in our view, they often turn out to be counterproductive. We have seen many investors who purchase a variable annuity and ultimately learn they’re trapped in a product with high fees, stiff penalties and less growth than they expected.

An Annuity Overview: Types and Comparison

Before focusing on the pros and cons of variable annuities specifically, it is important to understand the different types of annuities and how they operate. Annuities typically have a two-part structure:

  • Accumulation period. During this time, you make a payment or a series of payments to fund your annuity and the custodian (generally an insurance company) invests on your behalf into the funds you select as “subaccounts.” As dividends and capital gains are reinvested, the account’s balance continues to grow over this span of time.
  • Annuitization. At a specific time, either a fixed date or at your request as spelled out in the contract, your annuity’s balance is converted into a series of periodic payments, or “annuitized.” In most annuities, these will continue for the rest of your life (though they may only occur over a fixed period, depending on the annuity’s structure). At annuitization, your investment usually becomes the property of the insurer and it can be difficult (if not impossible) to recover your money after this point.

Annuities can be grouped into three classes based on how they provide their returns:

  • A fixed annuity periodically pays you a set rate of return based on the amount accumulated in your annuity’s account. They are usually the least expensive annuity in terms of fees, but generally offer a correspondingly low rate of return.
  • An equity indexed annuity generally provides a minimum fixed rate of return (similar to a fixed annuity), but this rate may increase based on the performance of a security to which it’s linked. In most cases, the security will be a fund that attempts to mirror a stock market index, such as the S&P 500. These annuities can come with higher fees relative to investing in an index tracking fund directly. Not to mention, the annuity company might keep any annual market return above a given percentage, say 10% for example.
  • A variable annuity also provides periodic payments, however, the amount of return during the accumulation period varies based on the performance of the investments made into subaccounts. For example, if the investments decline in value, your payment may go down as well, and your principal may be at risk.

For more on understanding annuities, we encourage you to read our guide, Annuity Insights: Nine Questions Every Annuity Investor Should Ask.

Why Buy a Variable Annuity? A Hard Question to Answer

You may have already had a financial advisor describe a variety of advantages related to variable annuities. He or she probably went over some of the following selling points:

Protection: Variable annuities might seem attractive because they offer protection against loss, through guaranteed growth or benefit riders (amendments to the insurance policies), which other investments can’t provide.

Flexibility: Variable annuities can be customized with many features through riders, allowing them to include protection against losses from a wide variety of potential events or enhance the annuity’s benefits to fill a specific role. That said, these riders often increase the annuity’s fees.

Growth: Relative to other annuities, variable annuities have the most opportunity for growth, as fixed types tend to offer low rates of return while indexed varieties come with participation rates and/or caps that variable annuities don’t. But remember: All this comes at the cost of protection, since variable annuities (without the appropriate riders) can lose principal.

Lifetime payments: Annuities can provide an income stream for life. However, since some annuities may only pay over fixed terms, it’s important to check their contract to verify this feature is standard or if it must be purchased through a rider.

Contribution limits: There are no limits on how much can be invested in an annuity bought with post-tax money, whereas most other means of tax-deferred investment have contribution limits.

Tax advantages: Trading in annuities doesn’t incur capital gains taxes like those in traditional brokerage accounts, with taxes only repaid only once the income stream begins.

What’s Not to Like? In Our View, A Lot

Once you’ve heard the sales pitch about variable annuities from your advisor, they may sound amazing. But, don’t buy one until you have considered its cons. Variable annuities have many disadvantages when looked at as primary investment vehicles, including:

Market risk: Deposits into a variable annuity are usually vulnerable to potential losses. Some plans give you the opportunity to purchase a rider at extra cost that can mitigate possible losses, but such riders often only guarantee a rate similar to what you might find in a fixed annuity—which raises the question of whether it’s worth paying more for the variable annuity in the first place. It’s crucial to consider the cost of any rider that protects against losses, weighing how much it will inhibit growth relative to how much it could save.

Cost: Relative to many other means of investing, variable annuities tend to be more expensive to investors. It’s possible for variable annuity fees to reach over 3% annually, which can limit how quickly your funds grow even if the market is galloping higher.1 In contrast, many competing investments, including mutual funds, offer fees of less than 1%.2

Complexity: Annuities can have encyclopedic contracts that are full of financial jargon and legalese. These contracts often define terms much more narrowly than how they are used in day-to-day conversation, so it can be easy to mistake what you might hear from the person selling you the annuity. In the long run, no matter what type of glowing language your advisor uses when recommending an annuity, what matters is the language that’s actually in the contract.

Illiquidity: While annuity proponents highlight many benefits, they often gloss over a key factor that should be important to investors: How easily can you get your money back? As with many questions about annuities, the answer is a bit complicated. They often come with high surrender fees that penalize early withdrawals and impose withdrawal limits that can make it very difficult to extract your money even before the contract is annuitized. And once you annuitize to begin receiving payments, your money might be completely inaccessible unless you’ve paid extra for a rider that allows you to convert your balance to a lump sum.

Help or Hindrance?

Now that we have gone over the pros and cons of variable annuities, we want to provide some guidance you can use to determine whether this type of investment is likely to be useful as part of your personal portfolio.

First, ask yourself why you have purchased or are considering purchasing a variable annuity. If the answer is growth, you may be disappointed. Keep in mind that this type of product can often be lucrative—but not necessarily for you. When you buy an annuity from a broker or insurance agent, the salesperson gets an upfront commission that can be as high as 10% or more. Variable annuities’ annual management fees along with rider costs can also drastically depress your returns over time.

Ultimately a variable annuity is an insurance product. If you expect to live a long life, for example, a variable annuity with lifetime pay-outs can guarantee you’ll have an income beyond Social Security for as long as you live. However, if you are looking for guaranteed income, you might be better off in a fixed annuity, where returns aren’t tied to the volatile the stock market and management fees are lower. You can also get other forms of protection against loss by purchasing riders for your variable annuity. But if you are going to pay the added cost, it can be useful to consult with an adviser capable of simulating a variety of potential outcomes to see whether the added protection justifies the increased fees.

Some people choose variable annuities if they have maximized the funding of other types of tax-advantaged accounts. This makes sense on the one hand, as the tax advantages offered on annuities can amplify the compounding growth, particularly over the long term. On the other hand, the upfront costs, ongoing fees and relative illiquidity create some built-in disadvantages. These negatives can counter much of the benefits from their tax-deferred status and make it harder to actually use the gains you earn until you annuitize your contract.

If you are trying to grow your portfolio, those initial and ongoing costs are a built-in headwind against growth that never goes away. Think of it this way: These fees aren’t just money you will never get back, but also money that you can’t reinvest. Over longer time horizons, this ability to reinvest can amplify the actual return on investment. As such, you may want to make some calculations when considering an annuity to see whether the benefits outweigh the opportunity costs.

As we’ve mentioned previously, annuities can severely restrict access to your money. If at any point you need that cash to cover short-term or unexpected costs, it may be either completely unavailable or very costly to access through surrender fees and potential tax penalties. Be sure to consider this in your financial planning before your lock away a big portion of your hard-earned money in an account that only is only paid back to you one small payment at a time.

Having limited access to your money can be particularly challenging as you age and unexpected expenses (particularly in health care) become more common. You hope the rest of your life means many healthy years. But, if your health takes a turn for the worse after you buy an annuity, do you have sufficient emergency funds available? In the worst-case scenario, you may not live long enough to receive enough payments to recover the value of money your annuity has tied up. While annuities generally offer a death benefit that will pass this on to your heirs, the associate annuity taxation can be complicated—and costly. Even getting death benefits may require a rider that has additional costs, and enhanced benefits may be even more expensive.

We Can Help You Examine Your Variable Annuity Contract

If you are a qualified investor, and you have questions about your annuity or would like a second opinion on an annuity you are considering, request an appointment with us now. We have Annuity Counselors on staff who can review annuity contracts to help you understand what your annuities offer and how they might fit in with other retirement investments. We also encourage you to look at our selection of annuity guides for additional insights into these products.


1 Potential variable annuity fees of 3.44% based on average annuity fees of 1.21%, average annual subaccount mutual fund fee of 0.63%, and Guaranteed Lifetime Withdrawal Benefit rider fee ranging between 0.35%–1.6% annually. Sources: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102, 114; Investment Company Institute, 2017 ICI Fact Book, https://www.ici.org/pdf/2017_factbook.pdf, 89.

2 Source: ICI Research Perspective, “Trends in the Expenses and Fees of Funds, 2016,” https://www.ici.org/pdf/per23-03.pdf

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