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3 Reasons to Buy a Variable Annuity

I recently ran across an Investment News article that noted the strong sales of variable annuities in 2006, and it got me thinking: What are the best reasons to invest in these aggressively sold, high-fee products? Here are the top three I came up with:

•  Your broker's Ferrari is getting a little long in the tooth, and you want to make sure he can afford a shiny new one;

•  You're not eligible to invest in a hedge fund, but you still want the cocktail-party cachet of paying outrageously high fees for mediocre investment performance;

•  You've maxed out your 401(k) and IRA contributions, are still 15 to 20 years from retirement, are in a high tax bracket now but expect to be in a lower one when you retire, want a product that will provide you with a "guaranteed" minimum income, and don't want to spend much time on investment research.

In all seriousness, variable annuities don't seem like the best choice for many of the people who buy them, thanks to those famously hefty fees. Yet they continue to sell well, spelling good news for companies like Hartford Financial (NYSE: HIG  ) and Prudential (NYSE: PRU  ) , and some feel that they serve a need for investors in certain situations. What's the scoop?

The good
When you buy a variable annuity, what you usually get is an investment in a managed pool of assets, called a subaccount, that comes with an insurance contract intended to protect you from losing too much money. For various arcane legal reasons, that insurance contract -- sometimes called a wrapper -- allows your investment earnings to grow tax-deferred, meaning that you don't have to pay taxes on your gains until you start receiving payments. In exchange for your investment, the insurance company agrees to pay you a stream of income over time -- sometimes for the rest of your life, sometimes for a set period. That stream can start immediately upon payment of a lump sum (with what's called an immediate annuity) or start at some set point in the future (a deferred annuity), and the size of those payments is dependent on the performance of the underlying investment over time.

The bad
All that sounds good, but here's where things get ugly: Variable annuity buyers pay an awful lot for those privileges. First, you'll pay a management fee on that subaccount, which is similar to the fee you'd pay on an actively managed mutual fund, and the subaccount may also have a load. In addition to those fees, annuities carry something called a "mortality and expense" (M&E) charge, which pays for the insurance contract, administrative fees, and part of the seller's commission. Together, these fees can amount to as much as 2% or more annually, making an annuity almost twice as expensive as the average mutual fund.

And on top of all that, if you cash out before a set period of time (which can be as long as 12 years), you'll have to pay something called a "surrender charge." When you buy the annuity, the broker or insurance rep gets a commission. That commission is essentially an advance against future M&E payments, and if you don't stay invested long enough to pay off that advance, the company will collect it from you via the surrender charge. These charges can be as high as 9%, and though they generally decline over time, they should discourage any investor who might need that investment back before the surrender charge period expires.

As you can imagine, all those fees take a huge bite out of performance -- enough to completely offset the supposed advantage of the annuity's tax-deferred status in many cases. (Check out the example near the bottom of this page from our Retirement Center to see why.)

The upshot
So who should buy these things? Well, if you meet all the criteria listed in the third bullet point up above, or if you're in or near retirement and are drawn by the idea of an assured minimum income for life, you might be a candidate -- and you should head over to the Fool's annuity primer to learn more about these products. If you do decide an annuity is for you, consider letting your broker find another way to finance that Ferrari -- there are lower-cost varieties available directly from leading fund companies such as Vanguard and Fidelity. But for most investors, buying a portfolio of solid long-term performers like Nokia (NYSE: NOK  ) or Starbucks (Nasdaq: SBUX  ) -- or even just a simple index fund -- will yield much better results in the long run.

Investing the right way is essential for the success of your retirement plan. For advice on how to put together the best retirement portfolio for you, take a 30-day free trial of the Fool'sRule Your Retirement newsletter service. You'll find simple directions that will set you on your way to a successful retirement.

Starbucks is a Stock Advisor pick.

Fool contributor John Rosevear does not own any of the stocks mentioned in this article. The Motley Fool has a disclosure policy.

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  • Report this Comment On May 04, 2009, at 4:05 PM, nochoaveragefool wrote:

    This article was written just months before we seen the market tank 40%. Sure the knock on annuities is and has always been their fees, but ask someone who has lost 40% of their entire savings in stocks, and low fee mutual funds if they would exchange the 2 to 3% fees for the 40% loss of all their hard work, and see what kind of answers you get? We all protect our Homes and our Automobiles with insurance and in most cases our lives, so why dont we protect our life savings with insurance??? That is essentially all an Annuity does for you! By the way, If you are already paying 1% to 2% in fees with no downside protection, then how much more is an Annuity really costing you?? You fund manager lost you 40%+ from Nov. 2007 to Jan. 2009 and you paid Him/Her/Them a fee, How does that make you feel??

    Like any investment vehicle out there, there are always Pros and Cons. I happen to believe there are More Pros than Cons with Variable Annuities!

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