Is a variable annuity right for me? Even though your insurance agent will insist differently, the answer to that question is an unequivocal “no.” Variable annuities are contracts sold by insurance companies that conceptually seem appealing but are inefficiently priced to benefit the insurance carrier over the investor.

The sales pitch of the variable annuity contract is it helps investors accumulate funds for retirement while also providing life insurance benefits. These products succeed at neither objective particularly well as the bells and whistles of the insurance product siphon off huge portions of the investor’s capital. Further, better investment, insurance, and tax planning alternatives are readily available.

The bottom line is that the salespeople who push these products are eying the huge commissions they will receive rather than the financial well-being of their clientele.

The Nuts and Bolts of Variable Annuities

Variable annuities are usually sold as means to accumulate retirement funds. In the accumulation phase, the investor makes regular payments to an insurance company. These funds are then invested into mutual fund-like sub accounts. At retirement, the investor then signs over the accumulated funds to the insurance company in exchange for lifetime, periodic payments. During the accumulation phase, a life insurance benefit is usually contained within the contract. This feature provides a payment to the annuitant’s beneficiaries in the event the investor dies prior to the payout phase. Usually, the payment is the greater of the funds held or some guaranteed minimum.

For example, let’s say an investor is making payments on a $100,000 variable annuity contract. The investor dies during the accumulation period, when the account balance is only $80,000. If the contract specifies that the beneficiaries will receive at least $100,000 upon the death of the investor, the death benefit will be $20,000. If the account was valued at $120,000, the beneficiaries would receive that exact amount, and no additional death benefit would be paid.

With variable annuities, the value of the accumulated funds depends directly on the underlying investment accounts selected. Insurance company sub accounts are nearly identical to mutual funds. The investor is usually able to choose from among equity, bond, money market, and international fund accounts. Like 401(k) plans, IRAs, and SEP (Simplified Employee Pension) accounts, the investment holdings grow in a tax-deferred manner. So, any dividends, interest, and capital gains are not taxed. When funds are withdrawn, the excess of the account value over the amounts paid in is taxed at ordinary income tax rates.

The Colossal Costs of Variable Annuities

The mechanics of variable annuities might make these products sound like decent investment options – until you factor in a variety of fees. Variable annuities are some of the most fee-heavy investments on the market. Commissions typically start at 5%. Ongoing carrying costs can result in 3-4% of the account balance being devoured each year. Also, taking cash out of a variable annuity within the first eight years can result in surrender charges that would make even Wall Street bankers cringe. The prospectus is the most important source of fee information for the investor. Here is the typical fee structure for a variable annuity :

These ongoing expenses add up to a return-on-investment disaster. Imagine paying $3,400 in fees on a $100,000 variable annuity year after year . To make matters worse, the life insurance coverage purchased by the mortality charges is consistently overpriced.

If the commissions and carrying costs weren’t bad enough, there’s the issue of the surrender charges. Surrender charges are assessed when the investor withdraws cash during the early years of the accumulation phase. The charge is assessed on the value of the withdrawal, and can be triggered within a 6-8 year window after an annuity is set up. The following is an example of a surrender charge schedule:

The commissions, carrying costs, and surrender charges result in one very unfavorable investment vehicle. With all of the alternatives available to investors, the variable annuity contract should be dead last on the list of investment options to consider.

The Alternatives to Variable Annuities

The objectives of variable annuity contracts can be met more efficiently with other financial instruments. Insurance agents often omit this fact deliberately.  As with most most investment products that have a lot of embedded options and complexities, it’s always cheaper to recreate the product by breaking it down into its components

If the investor’s goal is to defer taxes on investment income, a variety of tools exist. First, if the investor participates in an employer-sponsored retirement plan like a 401(k) or 403(b) plan, funding these retirement accounts should be his or her first priority. After fully funding all employer plans, an IRA account can be funded each year as well. If the investor is self-employed, a SEP account can be put into place allowing substantial annual contributions. Some financial advisors commit the unforgivable practice of selling variable annuities inside other tax-favored accounts. This is a redundant and wasteful approach. Placing a tax-deferred variable annuity inside of a tax deferred account like an IRA provides no additional tax benefit to the investor. If the investor’s goal is to build an investment portfolio, a slew of no-load mutual funds and low-cost ETFs are available. Holding a portfolio of individual stocks is an even cheaper alternative. Further, with any of these securities, the investor can avoid the steep surrender charges associated with variable annuities. Finally, if the investor’s goal is to put life insurance protection into place, a simple and straightforward term life policy from a highly-rated insurer is the best option. Term life policies are pure insurance, and thus do not contain extraneous fees.

Resisting the Variable Annuity Sales Pitch

Despite all of the negatives against variable annuities, these products continue to be pushed aggressively in the investment marketplace. This is unfortunate since these products will never make good financial sense for a vast majority of investors. Only in rare cases where an investor has fully utilized all other tax-deferred vehicles could a variable annuity be given a second thought. Even in such a case, the investor is frequently better off in a plain-vanilla, fixed annuity.

Multitudes of investors will be unable to resist presentations of professional financial salespeople. However, now that you have an insider’s view of variable annuities, perhaps you won’t be the one to get stuck with an inefficient investment product.