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Pitfalls of Variable Annuities

Samuels Yoelin Kantor LLP

What’s a Variable Annuity?

Basically a variable annuity is a life insurance contract, a wager on the life expectancy of a person. That person is the “annuitant” for purposes of the contract. The person who holds the contract is “the owner.” They’re not necessarily the same person.

In return for an investment of an initial lump sum or series of premium payments over time, the owner begins receiving an income stream at a certain milestone, perhaps when the annuitant reaches retirement age. That income stream keeps coming for as long as that annuitant lives. They may well live longer than the insurance company’s initial estimate. That makes annuities attractive for people concerned about outliving their savings. There are also many different configurations, add-on features, and other options available for the various annuities being sold today. These add-ons can make the advertised returns can seem attractively high, which is the core of the sales pitch.

Sound good?

A variable annuity can be a good investment, especially for someone who desires a stream of income for life. It has certain tax advantages as well, deferring income tax on growth until the owner receives payments. But investors must keep in mind the costs and risks of investing in a variable annuity. The increasing complexity and fees associated with these products are often misunderstood.

Variable annuities have been around for some time. Each year the industry tweaks and modifies the terms and options for new contracts. A few decades ago, variable annuities acquired a fairly poor reputation in the industry. And at another point, because interest rates in the broader economy fell relative to their guaranteed returns, variable annuities accidentally became a splendid deal for investors.

Of course there are complications. The money you put into the variable annuity usually goes into one or more “sub-accounts,” which are tied to market performance and corresponding managed investment funds. These can range from conservative to extremely aggressive fund options, which should suit the annuity owner’s investment needs and risk tolerance.

Variable annuities often have a host of optional benefit riders. Usually a “death benefit” is included in the contract. This term generally provides that if the annuitant dies before the milestone when the income stream begins, the surviving owner (or the annuitant’s estate, or a named beneficiary in the contract) can get back the money invested in the product. There may be “enhanced” death benefit riders available for additional fees, such as a rider that “steps-up” the amount of the death benefit beyond just what was originally invested. Other “living benefit” riders may provide certain minimum guarantees that enhance how the eventual income stream will be calculated. Again, these riders cost the investor by adding to the annual fees charged to the annuity owner.


These optional riders can create enormously complex math problems when trying to figure out the value of what you’re actually buying.

Some smart investors may feel, perhaps rightfully, that they’re perfectly capable of mastering the nuances of this net-present-value math homework on their calculators and spreadsheets. And they may feel, perhaps rightfully, confident about their chances of living to a healthy old age. But even an investor who has done the math perfectly may miss some of the other possible pitfalls of a variable annuity investment: Here are just a few observations.

  1. Variable annuities tie up principal. Normally the owner surrenders access to the principal until the later of the annuitant reaching age 59-1/2 (that’s driven by tax law), or the expiration of some initial waiting period regardless of the annuitant’s age, commonly 7 to 10 years. Pulling out money before then can mean paying hefty surrender charges and tax penalties. Ten years is a long time for elder investors to lose access to their money.
  2. There may be fees and other charges that eat into the value of the account, undermining the ultimate payoff. These include surrender charges, mortality and risk charges, annual sub-account fund expenses and/or administrative fees, and other annual fees for special riders. These conditional riders, assessed as percentage fees, may provide “benefits” and “protections” that are actually way out of proportion with their costs.
  3. Some of these annuity contracts are structured with multiple decision-points along the way. A wrong step on that logic tree, a poorly thought-out decision or a missed deadline, can have a significant adverse effect on your returns. And there is no way to undo that. The hefty prospectus and annual supplements that control the terms of the annuity and contain these material terms are usually long, dense, and cross-referenced, which makes it difficult even for professionals to understand.
  4. Some of these contracts are structured so that the annuity’s issuing company is permitted to adjust the percentages of your returns, depending on market conditions or other variables that you’re not in control of. Obviously this changes the nature of the guaranteed income stream and makes it even more difficult to calculate the value of what you’re buying.
  5. Investors should take a step back and compare the expected returns of this variable annuity, including all associated fees, with the returns they might get from another type of investment. This is the investor’s “opportunity cost”. What else might have been done with this money? For example, investing directly in a mutual fund that is identical to an annuity sub-account fund saves you the annuity’s additional management fees, and may also keep your investment liquid.

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