Variable Annuity

A Variable Annuity is a complex financial product sold by an insurance company. Think of it as a contract that bundles investment options, similar to mutual funds, inside an insurance wrapper. Its main sales pitch is twofold: to grow your money on a tax-deferred basis and to potentially provide you with a stream of income in retirement. The “variable” part is key—unlike a fixed annuity with a guaranteed interest rate, the value of your account and the income you eventually receive can fluctuate, sometimes dramatically, based on the performance of the investments you choose within the annuity. These investment options are called sub-accounts. While it sounds like a neat all-in-one package, this combination of investing and insurance often creates a product that is both incredibly complex and laden with high fees, making it a frequent subject of criticism in the investment world.

A variable annuity's life is typically split into two distinct phases. Understanding both is crucial to seeing the full picture.

This is the saving and growth period. You contribute money, either as a lump sum or in periodic payments. This money is then invested in the sub-accounts you select from a menu offered by the insurance company.

• Investment Choices: These sub-accounts are essentially mutual funds covering various asset classes like stocks, bonds, and money market instruments. Your account's value will rise and fall with their performance.
• Tax Deferral: During this phase, any investment gains—dividends, interest, or appreciation—are not taxed. They are allowed to compound year after year without an annual tax bill, which is one of the product's main selling points. This is the same tax treatment you get in more common retirement accounts like a 401(k) or an IRA.

Once you're ready to start receiving income, typically in retirement, you enter the payout phase. You have a few choices here:

• Systematic Withdrawals: You can take money out as needed, though you'll start paying taxes on the gains.
• Annuitization: This is the process of converting your account's lump-sum value into a guaranteed stream of regular payments. You can choose payments for a specific period (e.g., 20 years) or for the rest of your life. This is where the insurance component truly kicks in. Once you annuitize, the decision is usually irrevocable.
• Lump-Sum Withdrawal: You can cash out the entire annuity. However, this will trigger a potentially massive tax bill on all the accumulated gains and could also incur a hefty surrender charge if done within the first several years of the contract.

For the disciplined value investor, variable annuities often raise more red flags than they do flags of victory. The promised benefits frequently come with significant, and sometimes hidden, costs and complexities.

Variable annuities are notorious for their layers of fees, which can seriously erode your investment returns over time. It's like a Russian nesting doll of costs.

• Mortality & Expense (M&E) Risk Charge: This is the core insurance fee, typically 1.0% to 1.5% annually. It compensates the insurance company for the risk it takes, including the cost of providing a standard death benefit.
• Administrative Fees: A flat annual fee or a percentage of your account value to cover record-keeping and other administrative tasks.
• Sub-Account Fees: Each underlying mutual fund you invest in has its own expense ratio, just like any standalone mutual fund. These can range from low to very high.
• Fees for Riders: Want extra features like a guaranteed minimum income or a higher death benefit? You'll pay for them with optional “riders,” which are add-ons that tack on even more annual fees.

When you add all these up, it's not uncommon for a variable annuity's total annual fees to exceed 2% or even 3%, a massive hurdle for your investments to overcome.

The tax deferral sounds great, but it comes with a nasty sting in the tail.

• Ordinary Income Taxation: Unlike stocks or mutual funds held in a regular brokerage account, where long-term gains are taxed at lower capital gains rates, all investment gains from a non-qualified variable annuity are taxed as ordinary income upon withdrawal. For most investors, the ordinary income tax rate is significantly higher.
• No Stepped-Up Basis: When an investor dies holding stocks or mutual funds, their heirs receive the assets at a “stepped-up” cost basis equal to the market value on the date of death, erasing any capital gains tax liability. Variable annuities do not receive this favorable treatment. Your beneficiary will inherit your cost basis and will have to pay ordinary income tax on all the gains when they withdraw the money.

From a value investing standpoint, which preaches simplicity, low costs, and tax efficiency, the variable annuity is often seen as a solution in search of a problem. Why pay 2.5% in annual fees for tax deferral when you can get the same tax deferral in a 401(k) or IRA while investing in low-cost index funds for a fraction of the cost (often under 0.10%)? The product is a salesperson's dream because of the high commissions they earn, which is a cost ultimately borne by you, the investor. For the vast majority of people, a better strategy is to first maximize contributions to low-cost, tax-advantaged retirement accounts. If you still have money to invest after that, a simple taxable brokerage account with a focus on tax-efficient, buy-and-hold investments is usually far superior to the high-cost, tax-inefficient structure of a variable annuity. Always demand the prospectus and read the fine print. More often than not, you'll find that the complexity and costs associated with variable annuities are a poor value proposition for building long-term wealth.