We often evaluate an investor’s portfolio and see a variable annuity as part of the portfolio inside or outside an IRA. I believe they are over-used and should be evaluated carefully. There are a number of features that I dislike:
High Costs. Most variable annuities that are “sold” have internal expenses greater than 2% while some are between 3% to 4%. Richard Toolson, an Accounting Professor at Washington State University, has looked at the break-even analysis for variable annuities vs. investing the same funds in a lower-turnover stock index mutual fund — assuming both earn the same pretax return. According to his calculations, an individual in a 36% tax bracket will never come out ahead by investing in a variable annuity due to the prolonged drag of fees and tax issues.
Tax Inefficiency. If you own an equity investment in a taxable brokerage account, it will qualify for long-term capital gains tax treatment when it is sold in the future. That same type of investment held in an annuity will be subject to ordinary income tax treatment when money is withdrawn.
Inheritance Issues. Heirs will receive a step-up in basis on traditional investments with unrealized gains with an owner dies. But the heir receives no step-up in basis when that money is held in an annuity. Step-up in basis is a powerful tool to reduce taxes for the next generation.
Liquidity. Variable annuities sold by brokers for a commission typically lack liquidity and can tie consumer money down with prolonged surrender penalty periods.
Insurance Component. “Insurance” in variable means there is some type of guarantee that you’ll receive your money unless you purchase a rider for an additional cost over and above the already high base cost of the annuity. These guarantees come at a cost and may pay off in some cases.
Of course, there are brokers who will refute every negative point I make about annuities. And, I agree that there is no single right answer when it comes to the annuity question. Just be sure when considering an annuity that your advisor is an RIA who upholds the fiduciary standard and not a sales person functioning as an advisor. It will help ensure that the advisor is not influenced by the high commissions of many variable annuity products.