What are the best reasons to invest in these aggressively sold, high-fee products? Three come immediately to mind:

  • 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, 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, you usually get 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 a decade or more, 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 extremely high, and though they generally decline the longer you own the annuity, they should discourage any investor who might need that money 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.

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 -- or even just a simple index fund -- will yield much better results in the long run.

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This article, written by John Rosevear, originally ran in April 2007. It has been updated by Dayana Yochim. The Fool has a disclosure policy.