Many Questions Arise When Considering an Investment in Variable Annuities


Sales of deferred variable annuities have increased since the 2008 market crash as investors wary of the stock market are lured by promises of guaranteed lifetime income and protection against market declines, according to a Bloomberg article by Margaret Collins entitled “Lifetime-Income Promise Fuels Surge in Variable Annuity Sales.” But many financial advisors are not recommending variable annuities to their clients because of the high commissions and other costs and the complexity of the product that requires an actuary to determine whether or not the benefits exceed the costs, according to Lavonne Kuykendall’s InvestmentNews article entitled “Annuity fees a turnoff for clients and advisers.”

Annuities are insurance contracts/products that are issued by insurance companies and sold by a variety of brokers with insurance licenses. There are two kinds of annuities: immediate and deferred. Both kinds can be either fixed or variable.

An immediate annuity typically converts a deposit of cash into a stream of income payments. The amount of the income payments is affected by existing interest rates, actuarial data like the annuitant’s age and health, and how the annuity is taxed.

A deferred annuity is even more complicated. It is a two-phase product. Phase one, the deferral period, allows an investor to invest funds in a limited menu of fund-type investments that can grow tax-deferred. In the deferral period, which can last 10 years or so, the investor agrees to limit withdrawals a certain percentage and pay a significant penalty charge if more is withdrawn. In other words, most of the money is effectively “locked up” for many years.

Most of the negative press concerns deferred variable annuities (though all annuities have pros and cons). During the deferral period of a variable annuity, the deposited money may increase or decrease in value, depending on the performance of the underlying investments, and the effect of various charges. At the end of the deferral period, the investor can usually withdraw the entire account value and walk away without a penalty, or annuitize it ? i.e., convert it into an immediate annuity.

Most deferred variable annuities provide some kind of guarantee protecting against market declines. It may be a guaranteed death benefit or guaranteed lifetime income, or both. Both can be are lost, however, if too much is withdrawn in the deferral phase, or the investor does not annuitize.

The criticisms of deferred variable annuities are important and basic: (1) they are too hard to understand, (2) they are too expensive relative to other “safe” investments, (3) the expenses are hidden and tricky, (4) the money is lock-up for years, unavailable for emergencies except for a nominal annual withdrawal benefit, (5) surrender charges are often not well explained to the investor, (6) the array of investment choices is limited and often underperforming, and (7) high commissions provide perverse incentives for some to sell the product regardless of its unsuitability (for example, sales to octogenarians are not that uncommon).

The InvestmentNews article cited one advisor as calling annuity guarantees “difficult to assess” and saying that “the complexity of variable annuities with optional riders would almost require an actuary to properly assess them, though he does see benefits to some annuities.”

“All the advisers agreed that commission-based distribution is a problem and that some clients end up getting out of the annuity but have to pay a hefty surrender fee to do so,” according to the article.

“To design a good product, you’d have to eliminate the distribution source, a product with no bells or whistles, no load, no commissions” that combined inflation-protected securities with guaranteed income,” another advisor was quoted as saying.

The advice given in the February 2008 issue of Smart Money magazine is still good: Brokers and insurance companies tout the tax advantages of variable annuities, which grow tax free like IRAs. But distributions from variable annuities are taxed at ordinary income rates ? roughly double the capital gains taxes that would be owed if the assets were held in a taxable account. Once you add in payments for the underlying investments and insurance protection fees, a variable annuity could cost an investor five times as much as an investment held in a taxable account. Put $20,000 in a low-cost annuity for 20 years, for example, and you could still have earned $15,000 less than if you had made the same investment in a taxable account.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving variable annuities. For further information, please contact us.