Financial professionals sometimes sell variable annuities to investors promising market-like growth with less “risk.” Unfortunately, the truth is a little more complicated. Variable annuities are confusing, often even to the people selling them. There are a wide variety of variable annuity contracts and a bewildering array of terms and conditions attached to them. These provisions need to be examined closely because they can have a material impact on your ultimate return.
At Fisher Investments, we have helped many clients navigate most types of annuity contracts and their associated issues. We believe it’s important for investors to have a clear understanding of what annuity ownership entails and how they compare to other available investment options.
Features of Variable Annuities
Like all annuities, variable annuities are insurance products that promise to pay a stream of income beginning at a specific time in exchange for premium payments. Variable annuities have two distinct phases:
- The accumulation phase: The period when an investor makes premium payments. You can pay premiums either as a single lump-sum payment or as a series of regular contributions, depending on the terms of the contract.
- The payout phase: This is when the investor receives their guaranteed income, usually on a monthly schedule. The length of this period can range from a few years to payments life, depending on the terms of the contract.
Variable annuities differ from other annuities—such as fixed annuities—because of the variable rate of return during the accumulation phase. The annuity owner can direct funds into various “sub-accounts.” Sub-accounts work similarly to how mutual funds operate. Premiums are used to invest in securities. The gains or losses from these investments determine the variable return. Consequently, variable annuities are considered securities and must be registered with the Securities and Exchange Commission (SEC) as well as with state insurance regulators.
This arrangement allows deposits to fluctuate during the accumulation period, theoretically leading to a potentially larger income stream in the pay-out phase than with fixed annuities. However, losses are also a possibility. We’ll discuss this more later, but it’s important to note that variable annuities don’t protect you from loss.
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Salespeople for variable annuities typically target investors concerned about the possibility of outliving their assets—sometimes called “longevity risk”—because of a market downturn. So annuity salespeople often focus on terms such as “guaranteed income” or “lifetime income” that sound safe. Some investors see an annuity as a way to transfer their longevity risk to an insurer. However, how the insurance company structures the variable annuity can have a significant impact on the actual results.
Riders and fees can offset potential returns
While annuity salespeople often mention guarantees, they frequently neglect to mention that many of these benefits must be purchased as riders to the annuity contract. A rider is an add-on provision to a basic policy that provides additional features at an additional cost. Since variable annuities typically have annual fees of as much as 2.27%1—before rider fees are factored in—such features can create a strong headwind against your investments if you hope to see your deposits grow.
It’s also important to realize that while these features can sound attractive, there can often be conditions and stipulations. The annuity’s contract specifies what your annuity will provide—not what the salesperson says. For example, a rider for protection against loss usually only protects your deposits—not any gains on the investments. If you want to make sure the annuity benefit transfers to your spouse or heirs when you pass, that may require you to purchase another rider. The contract also, in most cases, likely requires you to have money left in the annuity to pass on.
Inflation hurts your purchasing power
Despite high fees, investors can still find the “guaranteed” nature of future payouts attractive. However, unless you purchase a rider (with another fee, of course) to dampen the impact, inflation can hurt you over the long term and most riders do not adjust inflation. Let’s look at an example of what you’d actually get back after you’ve owned an annuity for 10 years.
The scenario below assumes you bought your annuity with a lump-sum payment, there was no investment growth and inflation held to its historical rate of around 3%2. As the table shows, inflation erodes the purchasing power of $10,000 over time. After 10 years, your total payments would have lost around 23% of their original value. Even if you were to assume your deposits are made evenly, inflation still would have cost you roughly 12% in purchasing power. Importantly, neither scenario considers the fees charged over the years, making these outcomes look even worse.
As you can see, the reassurance you might hope to gain from a variable annuity is rarely straightforward. The features that seem most beneficial often can turn out to be underwhelming when scrutinized. Whether or not the trade-offs make sense depends on your individual needs and circumstances; however, in our view, it’s hard to find situations where the benefits 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 isn’t guaranteed: Unlike some other types of annuities, the principal in variable annuities 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 don’t always keep pace with inflation, depending on their terms. If your cost of living rises and your income stream does not, your retirement lifestyle could be in peril if your purchasing power fades over time.
- Inflexibility: Variable annuities usually have significant barriers that can make it difficult for an investor to exit the contract. If you need money prior to the payout phase, whether for an emergency or an investment opportunity, you may not be able to withdraw funds without incurring a serious penalty. These penalties may be reduced or eliminated over time but it’s often seven years or more from purchase.
- Insurer insolvency: Insurance-company default rates may be low, but you still have to assess the risk of one going bankrupt. If it happens, your retirement nest egg often goes with it.
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.
Of course, sales fees and commissions don’t even begin to account for annual fees. These charges can vary, but they generally include at least 1.4% (according to the SEC)3 simply to cover the annuity’s cost. Remember, money in a variable annuity is likely to be invested in mutual funds, which will also charge fees (averaging 0.98%)4. Factor in a couple of common riders—like a Minimum Death Benefit (0.56%5) and Guaranteed Lifetime Withdrawal Benefit (0.96%6) and your fees are sitting at 3.9%. 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 that earns an average of 10% annually over 10 years. After taking out the annuity’s fees and factoring in compounding interest, you’d end up with just over $17,000 through the annuity. Purchasing that same fund directly—less the annuity specific fees—would have resulted in earnings for you of nearly $22,000.
In this example, the annuity ends up costing nearly $5,000 in 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 isn’t 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 earlier than you intended, you are likely to incur a surrender charge. Additionally, taking too much money out could reduce the benefits of any riders for which you’ve paid.
Fisher Investments has analyzed thousands of annuities over the years and we have found initial-year surrender charges can be high. For example, a typical surrender fee might be 7% in the first year, 6% in the second, 5% in third and so on7. You might wonder why these surrender fees seem so punitive. The answer is simple and it's two-fold:
- To discourage you from doing what many annuitants want to do: leave!
- 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 purchased with protection riders, variable annuities offer essentially the same risk as a direct investment, but with higher fees. They also usually offer inferior levels of flexibility, liquidity, personalization and, crucially, return. If you want performance from your retirement investments, 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.8 We’ll analyze the annuities you own or are considering and help clarify exactly what these contracts truly provide.
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.
1 Source: Fisher Investments’ Annuity Evaluation services, as of 8/18/2022. Based on average expenses of 2,197 unique variable annuity policies between 7/1/19 and 8/18/2022
2 Source: FactSet as of 08/32/2022. Based on US BLS Consumer Price Index from 1926-2021 showing average 2.9%
3Source: Securities and Exchange Commission as of 10/31/2018. Updated Investor Bulletin: Variable Annuities https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_variableannuities#Annuity_Fees
4 Source: Fisher Investments’ Annuity Evaluation services, as of 8/18/2022. Average mutual fund or sub account fee. Based on average expenses of 2,197 unique variable annuity policies between 7/1/19 and 8/18/2022
5 Source: Fisher Investments’ Annuity Evaluation services, as of 8/18/2022. Average death benefit fee. Based on average expenses of 2,197 unique variable annuity policies between 7/1/19 and 8/18/2022
6 Source: Fisher Investments’ Annuity Evaluation services, as of 8/18/2022. Average income rider fee. Based on average expenses of 2,197 unique variable annuity policies between 7/1/19 and 8/18/2022
7 Source: Securities and Exchange Commission as of 10/31/2018. Updated Investor Bulletin: Variable Annuities https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_variableannuities#Annuity_Fees