Eric's Variable Annuity Page

Eric's Variable Annuity Page

This is an enumeration of some of the benefits and problems with using tax deferred variable annuities.

First, a variable annuity should almost never be used within an IRA. An IRA is already tax-deferred. To pay the extra fees to get tax-deferral when you already have tax-deferral makes no sense.

Second, it is possible to get similar tax deferral by simply investing in a tax-efficient mutual fund (e.g., a good tax-managed index fund). That would defer taxes on most of your gains until you withdrew it. If you are willing to not withdraw it until you are old, this method can give you nearly all the benefit of a variable annuity with none of the drawbacks.

Here's a link that discusses Tax-Deferred Variable Annuities pretty well:

Here's the analysis:

The biggest problem I have with variable annuities is their fees.

Surrender Fees. Most Variable Annuities have "surrender fees" that effectively prevent you from getting out of the variable annuity if you have second thoughts. As most variable annuities have outrageous fees and expenses, it is no wonder that variable annuity companies have found the need to penalize people who want out (because so many of them rightly come to the conclusion that they are getting a bad deal). Typically, the surrender fees amount to a sliding scale, where you have to pay a 7% penalty if you get out the first year, a 6% penalty the second year, a 5% penalty the third year, an so forth until you finally are able to get out penalty free after seven years. If you must get into a variable annuity, I strongly recommend that you get one with no surrender fees (e.g., Vanguard or TIAA-CREF).

Insurance Fees. For example, the last time I checked, Fidelity charges a relatively low insurance fee of 0.8% of the assets in a variable annuity per year (Vanguard charges much less -- about 0.25%). This may not sound like a lot but it is. For an account whose value is $100,000, this is basically giving Fidelity $800 of pure profit per year. I submit that even though their fee is relatively low compared to what many other companies charge for variable annuities, it is still a bad deal. Basically, what you get for this is a form of life insurance. Fidelity guarantees that when you die, they will deliver the then current value of your variable annuity to your beneficiary, but no less than the contributed capital. This may be beneficial for some people. But I submit that it is not a very good deal for most. Here's why:

Let's consider that 0.8% fee to be a life insurance premium (which is basically what it is).

First, check Eric's Life Insurance Page for a discussion of who needs life insurance and what the most cost effective way of buying it is. If you find that you don't need life insurance at all, this fact alone would prompt you to skip the variable annuity entirely in favor of tax-managed mutual funds.

Second, the amount of insurance coverage is extremely low -- very close to zero. The only way we get any payout whatsoever from this insurance fee (0.8% of assets in my example) is if the annuity's value drops below the contributed amount at the moment of your death. Assuming that you contributed about $50,000 several years ago, the current value might be about $100,000. You are paying insurance to protect you from a greater than 50% loss from its present level by the time of your death. This is pretty unlikely to happen, either if you die soon or, as is more likely, you die a long time from now. And as time progresses and the annuity grows, it will become less likely still (but the 0.8% fee will keep getting bigger, so you will be paying increasingly higher premiums while the possibility of getting anything in exchange lessens). The actual benefit you are getting is the difference between the contributed principal and the (lower) value of the annuity at your death, but only if that value is, in fact, lower than contributed principal. So the Expected Value you would be getting would be almost zero (because the chances of the annuity value going below your principal and the actual dollar benefit even if it did happen are both very low and get lower yet over time).

Third, even if your annuity did go below the level of contributed principal (which again, is pretty unlikely), it is a bad deal. The most you could ever theoretically get in exchange for your insurance premium would be the entire value of your principal. You would get this if your annuity totally lost ALL of its value at the moment you died. In my example, this would give you a benefit of $50,000. However, even in this extraordinarily unlikely best possible benefit scenario, you could do much better with a conventional term life insurance policy. In my example, the current value of the annuity is $100,000. That means you would be paying $800 per year as an insurance premium for an absolute maximum of $50,000 of life insurance coverage (it almost certainly would be less, though -- probably zero, as discussed above). If you instead put that $800 annual fee towards a conventional term life insurance plan, a 34-year old non-smoking male could get almost $3,000,000 of guaranteed coverage (i.e., an absolute minimum of 60 times as much as with the annuity, but probably a much higher multiple than that).

My conclusion is that, if you think that you really need this variable annuity insurance benefit, you would be dramatically better off with conventional term life insurance. If you decide you don't need life insurance, then you certainly don't need this variable annuity insurance benefit either and you would therefore be best served by instead contributing money to a tax-managed mutual fund, which would avoid the insurance fee.

My suggestion then, is that if you invest in a tax deferred variable annuity, do so with one which has no "surrender fees". Vanguard Variable Annuities and TIAA-CREF Variable Annuities, for example, meet this requirement.

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This page last updated 08/19/02