Is a variable annuity right for you?

February 19, 2001

You may be drawn to some features of these popular investment vehicles, but weigh their drawbacks carefully.


Is a variable annuity right for you?

Jump to:Choose article section... How variable annuities work Earnings: Not capped, but sapped Death benefits and other safety nets Annuities and inheritance taxes Who should go variable?

You may be drawn to some features of these popular investment vehicles, but weigh their drawbacks carefully.

By Susan Harrington Preston
Senior Editor

Variable annuities are on a roll. In 1998, their sales reached nearly $99 billion, triple the sales of fixed annuities. Ten years earlier, the ratios were reversed: Variables comprised 24 percent of all annuity sales, with the other 76 percent going for fixed annuities.

Variable annuities jumped in popularity because they offer the promise of bigger returns than their more predictable cousins provide. Some background: Like a fixed annuity, a variable provides income for life, based on the premiums you pay in. A variable annuity, though, doesn't promise a fixed payout; what you get also depends on the long-term earnings generated by the underlying investments. Those investments are mutual funds that primarily contain stocks—and stocks soared during most of the past decade. Meanwhile, the guaranteed returns of fixed annuities, which typically mimic the returns on bonds, tobogganed downward as interest rates fell.

Besides letting you participate in the stock market, variable annuities may provide an advantage if you live in a state that prevents annuity assets from being seized to pay malpractice judgments. "Some states, such as Florida and Texas, offer strong protection," says Joel Bruckenstein, a financial adviser in Pleasantville, NY. "Others offer limited protection." Physicians' personal assets have rarely been seized to pay malpractice awards, but there's no guarantee it won't happen to you—especially if you've signed a managed care contract with an indemnity clause.*

On the other hand, critics brush aside the idea of using variable annuities for asset protection, noting that trusts, among other arrangements, do the job with fewer downsides. Moreover, the state laws governing asset protection are often laden with conditions that severely limit their scope—and they may well apply to all annuities, not just variable ones.

Another strike against variable annuities is the sheer complexity of the policies, which can mask their true returns. For example, Tom Batterman, a financial planner in Wausau, WI, warns against highly popular index annuities, which track well-known market indexes such as the Standard & Poor's 500 Stock Index. The funds guarantee a modest rate of interest, so they have a floor and no ceiling. But in Batterman's experience, the annuities' terms typically aren't what they seem at first glance. "They promise index-type returns in good times and a guaranteed interest rate when the market goes down," Batterman says. "But the method of calculating the percentage of the S&P 500's gain that's credited to your annuity is misleading. The minimum rate guarantee often isn't what it seems, either."

Indeed, variable annuities can be such tricky investments that the SEC has recently published a cautionary brochure for consumers called "Variable Annuities: What You Should Know." It's available on the Web (

So if you already own a variable annuity or are thinking about buying one, read on.

How variable annuities work

A variable annuity is, in essence, an investment account. Your premiums are invested in mutual funds, called "subaccounts," which you choose from a list of funds the insurer offers. These can be stock funds, bond funds, or other investments, though as we've noted, equity funds predominate.

That doesn't mean subaccount funds are identical to similarly named mutual funds offered outside annuities. "The subaccount may be managed by the same people as the publicly available fund, but the holdings and performance often differ," says Mark J. Mackey, president and CEO of the National Association for Variable Annuities, an insurance-industry organization based in Reston, VA.

Like all investments in a mutual fund, the premiums you pay into a variable annuity can be either tax-deferred or post-tax, depending on whether the annuity is part of a retirement account.

Later, when you start getting payouts, their size is based on your annuity account's toal value. They can be a set dollar figure, or they can be a percentage of your account's value, which will rise and fall with the performance of its underlying investments. You can withdraw the money on any schedule you prefer—lump sum, monthly checks, or whenever you need cash.

A variable annuity has a safety net that resembles life insurance, in case you die before you receive payouts. This death benefit guarantees that your heirs will receive at least the value of the premiums you've paid. If the account's value has risen beyond the value of your premiums, your heirs get the higher amount, but they'll pay tax on the excess. And in many policies, a few more dollars per year in fees buys a "stepped up" benefit, in which your earnings are locked in every one to three years to assure that your heirs will benefit from gains.

Your variable annuity subaccounts are protected from the insurance company's creditors by federal bankruptcy law, so even if the insurer goes belly-up, you should get at least some of the money. If you're nervous, though, you might not want to rely on that reassurance alone. You can check the insurer's financial stability via investment rating services such as A.M. Best (, Standard & Poor's (, Weiss ( ), and Moody's (

Earnings: Not capped, but sapped

Most variable annuities levy at least three annual fees: an administration fee that's typically 1 to 2 percent of the assets, a subaccount management fee that may range from 0.15 to 1.5 percent, and a contract fee that's usually $20 to $40. All told, you'll probably pay 2 to 2.5 percent of your variable annuity assets in fees each year, in addition to the contract fee. The typical mutual fund may cost you a full percentage point less in annual fees, which can make a big difference over time.

If you close your annuity account within a few years after you open it, moreover, the surrender fee will take a scythe to your harvest. The fee usually runs 7 or 8 percent of assets during the first year you hold the annuity and declines to zero over seven years. It can go higher, though. "Ten percent is not uncommon for a surrender fee," says financial planner John Henry McDonald of Austin, TX. "And the term can last as long as 12 years."

Tom Batterman has seen worse. "The surrender fee for one annuity I saw reached almost 20 percent of assets," he says. "It was for eight years—and it went up during that time."

It's no surprise, then, that sales commissions for variable annuities are said to be roughly double those for mutual funds. Says financial planner George Paquin of Chelmsford, MA, "You can usually figure out the commission by looking at the combination of surrender term and surrender fee."

Salespeople also get commissions when you switch from one policy to another via tax-free "1035" exchanges, so called for the section of the US tax code that allows them. McDonald says that 40 to 50 percent of annuity sales are 1035 exchanges—and notes that many such exchanges occur before surrender fees lapse on the original policies. With every 1035 exchange, the surrender term starts up again.

One bright note: Many variable annuities will allow you to withdraw up to 10 percent of your account without paying a surrender fee, beginning one year after you buy the annuity.

Death benefits and other safety nets

Once you begin taking payouts, the death benefit vanishes and your heirs can inherit only what's left in the account when you die, whether that amount is more or less than the premiums you paid.

The death benefit doesn't help you, of course. While you're living, in fact, you can lose everything you invested in premiums, if the underlying mutual funds you choose tank. If that prospect scares you, consider allocating part of your premiums to a fixed-rate general account (sometimes called a "guaranteed account") controlled by the insurer, instead of to your subaccounts. It's like having a small fixed annuity within your variable annuity holdings.

Your return on the fixed-rate account will likely be lower than that on the mutual-fund subaccount. Still, the fixed-rate feature can be reassuring, especially if your retirement assets aren't extensive enough to weather a big dip in the markets, or if you're afraid your variable annuity account will underperform and run dry before your death.

Another option is to swap your variable annuity for a fixed annuity when it's time to begin payouts. The advantage: A fixed annuity guarantees you a specified income, typically for life; in contrast, you can outlive a variable annuity if you deplete the account.

While you're paying in premiums, you won't pay taxes on capital gains, dividends, or interest income in a variable annuity, whether it's part of a retirement plan or not. In a mutual fund outside a retirement account, on the other hand, you'd pay capital gains taxes on long-term gains in the year the fund realizes them, as well as ordinary income tax on any dividends or interest income.

That's why many financial advisers suggest using variable annuities only if you're already maximizing your tax-deferred contributions to a retirement plan. In that case, you can benefit from an annuity's tax deferral on earnings.

Even so, you might still be better off with a mutual fund. The tax advantage of the annuity may be comparatively minor, because many mutual-fund managers take steps to minimize capital gains taxes. For instance, if the manager trades stocks infrequently, most gains won't be realized even though the stocks appreciate. Or the manager may invest partly in tax-free municipal bonds. In the long run, and often in the short run, the mutual fund's return will likely surpass that of a variable annuity whose subaccount holdings are similar—despite the annuity's tax-deferral advantage.

Whether the annuity is tax-sheltered or not, you'll generally incur a 10 percent federal penalty if you withdraw your earnings before age 59 1/2. On the other hand, your policy may allow you to wait as long as you like before you begin taking withdrawals—a boon if, down the line, you opt to skip your payouts so your heirs will inherit more.

Annuities and inheritance taxes

As we've noted, once you start taking payouts, your heirs don't get a death benefit. Instead, when you die they inherit what's left in the variable annuity account. With an ordinary mutual fund, of course, they'd also inherit only what's in the account, but they'll get a lot less from the variable annuity. The reason: Mutual funds, when they're passed along, are taxed on a "stepped up" basis, but annuities are not.

Say you die with a mutual fund worth $30,000. That money would go to your heirs with a tax basis of $30,000, even if your cost for that fund was $10,000. When your heirs withdraw the money, they'll pay tax only on the amount over $30,000, and the appreciation will be taxed as capital gains. If they withdraw the full amount as soon as they inherit it, their capital gains tax bill will be zero.

The comparable variable annuity, however, passes to your heirs on the same tax basis as yours. That is, they'll pay tax on anything over the $10,000 originally invested. If they withdraw the $30,000 account balance when they inherit it, they'll owe ordinary income tax on $20,000. That'll be a hefty percentage, especially compared with a mutual fund's proceeds.

Who should go variable?

In sum, you should consider a variable annuity if:

• You practice in a specialty particularly susceptible to malpractice suits—and you live in a state that protects annuity assets from seizure.

• You're already setting aside the maximum for tax-deductible retirement accounts.

• Your retirement assets are too scant to weather a big drop in the stock market, and you want to look beyond bonds and CDs.

If you fit one of these descriptions, you may want to consider a variable annuity with reasonable costs. Glenn Daily, a New York City insurance consultant, suggests two possibilities: TIAA-CREF Life Insurance Personal Annuity Select (prospectus available at and Vanguard's Variable Annuity Plan (; click on the Services tab, then on Open a Variable Annuity Account). Both have annual expenses of less than 2 percent and no surrender charges, Daily says.

Otherwise, steer clear.

*See "Don't sign a sucker deal," June 5, 2000.


Sue Preston. Is a variable annuity right for you?. Medical Economics 2001;4:79.