No-load, low-fee variable annuities do exist, but few people ever buy them because they’re not actively marketed.  On the other hand, high-commission annuities are sold aggressively – mostly by insurance agents. Instead of educating their customers about annuities, many insurance agents take advantage of the fact that their customers don’t understand annuities.

As the baby-boom generation gets older, this is a growing and lucrative market. Variable annuity sales in 2006 were $160.6 billion, a jump of nearly 17 percent from 2005, according to the Insurance Information Institute.  Variable annuities now have more than $1.5 trillion in fixed-income and equity assets.

Here's why I wish that number were much, much smaller.

#1    The fees and expenses associated with variable annuities are far too high.  An annuity’s expenses are often more than 2.5 percent. That’s 12 times as high as those of many no-load index funds.  Most variable annuity investors also must pay an annual contract fee, usually $30 to $50.   Some annuities also impose charges every time the investor swaps money between investment sub-accounts.

#2  The sale of a variable annuity earns the agent a hefty commission, usually 6 percent.   Not surprisingly, given such a big payoff, agents position the product as having all sorts of benefits, though they never mention the major drawbacks.  (Some heavily promoted “bonus” annuity contracts pay commissions up to 14 percent.)  Whenever commissions are involved, potential conflicts of interest are not far behind. Unsophisticated investors usually don’t see this, and the insurance industry doesn’t give them any help.

#3  Variable annuity investors who want to take their money out before age 59½ are penalized by the IRS. Gains in the contract are taxed at ordinary income rates and may be subject to a 10 percent early-withdrawal surtax as well.

#4    Variable annuity investors who want their money back in the early years have to pay what I consider punitive surrender charges in the form of early-withdrawal fees that enrich the insurance company. Most of these fees decline year by year in an arrangement designed to make sure the insurance companies get their money in a lump sum if they have to stop charging the customer every year. For example, a seven-year surrender period might impose a 7 percent fee if you bail out in the first year, 6 percent during the second year and so on.  The earlier you take your money out, the more you pay in fees.

#5  The tax benefit of a variable annuity is often its strongest selling point – yet in real life it is usually a cruel illusion. Most people would never buy variable annuities if they really understood the way these investments are taxed. It’s true that capital gains, interest and dividends can build up inside an annuity on a tax-deferred basis. But when you take money out, by definition your first withdrawals are your gains – which are all taxable as ordinary income. Only after you have taken out all your earnings and paid tax on them can you start taking out your own money, on which there is no tax. The next item is another aspect of this harsh tax treatment.

#6  Even though your gains inside an annuity are long-term, you never get the benefit of long-term tax treatment.  They are all treated as ordinary income, and that can more than double the tax you pay, depending on your tax bracket. Consider this example: You originally invest $100,000 each in a tax-efficient no-load mutual fund and a variable annuity. After eight years, each one doubles in value and is worth $200,000. You then decide to take $40,000 out of the mutual fund and another $40,000 out of the annuity. If your cost basis remains $100,000 in the mutual fund, half the money you withdraw ($20,000) will be taxable at the long-term gains rate of 15 percent. You’ll pay $3,000 in taxes and you’ll have $37,000 for yourself. In the variable annuity, the entire $40,000 will be subject to taxes at your ordinary income rate, which we’ll presume is 25 percent. You pay $10,000 tax and you’ll have $30,000 for yourself. If you got a tax benefit from this, I certainly can’t find it.

#7  More than half of all variable annuities are sold to investors and placed inside IRAs and 403-b accounts. If there is any justification for the high costs of annuities, that justification is tax-deferral. But inside an account that is already tax-sheltered, there is no additional benefit to an annuity. The extra costs pay for nothing. In my view, placing variable annuities inside already tax-sheltered accounts should be illegal. I’m especially sad that teachers are often the targets of this deception.

#8  Variable annuities have unfavorable tax implications for heirs. If you buy a mutual fund for $10,000 and it’s worth $20,000 at your death, your heirs get a stepped-up basis of $20,000. That means they will eventually pay tax only on gains over $20,000 – and then at the lower capital gains rate. But if you leave a variable annuity in your will, your heirs have no such luck. They’ll pay ordinary income tax rates on everything in the contract that’s worth more than you originally paid for it. I’ve never known anybody who bought a variable annuity after this was explained by the salesperson.
 
#9  Diversification and asset allocation are still the best ways I know to maximize investment growth and control risk. But most variable annuities are woefully lacking in the asset classes that they offer.

#10 If your financial advisor is suggesting that you buy a variable annuity without fully educating you on these points, you could be in grave financial danger. The rest of this person’s advice has to be suspect, now and forever.  Trust is the primary ingredient in any investor-advisor relationship; it would be very hard for me to trust anyone who recommended such a product without fully explaining its ramifications.