When you buy a variable annuity, you invest in sub-accounts that will rise in and fall with the value of their securities. You receive some guarantees, for example, if you die before taking withdrawals your beneficiary will receive no less than your initial contribution even if the value of investments has decreased.

Before we start analyzing whether variable annuities make sense, let’s list their advantages:

• Tax-deferred accumulation
  • Death benefit protection
  • Longevity protection
  • Premium bonuses, and
  • Creditor protection in some states

Other than the first one, these advantages are quite small unless you are in a business where you could get sued, you live in a state where annuities are free from creditors, and sheltering significant assets from creditors is of value to you. In most cases you will not need longevity protection, that is, protection against outliving at least some of your assets, while you are accumulating wealth.

The disadvantages are as follows:

• Surrender charges if minimum holding periods are not met
• Mortality and expense charges
• Administrative fees
• Rider charges
• 10% penalty on withdrawals prior to age 59.5
• Withdrawals are of earnings first, then principal, and are taxed at ordinary income rates

A variable annuity could have an expense ratio of about 1.25% and investment management fees of 0.50%. Is that price low enough so that the after-tax value of the annuity exceeds the after-tax value of investments purchased outside of the annuity? Let’s look at an example:

Hypothetical Example – owner age 30, 28% tax bracket (therefore no net investment income tax from the Affordable Care Act), 8% investment return, $50,000 initial investment

At age 65, the account would be worth $417,333. A lump sum, which is not required but used here as an example, would trigger federal income taxes of $102,853, leaving the annuity owner with $314,479.

The net investment income tax would likely apply and decrease the account even further. Alternatively, by paying tax on gains each year, half at capital gains rates, half on ordinary income rates, with the same 0.5% investment management fee (so a net investment return of 7.5%), the account would grow to $370,284. Note that this alternative assumes the owner is making investment decisions himself as working with an advisor would likely increase the investment management fee.

If the tax bracket were increased to 33%, and the 3.8% net investment income tax applies, then the account would only grow to $336,951. The higher the tax bracket and the higher the investment returns, the more valuable the tax-deferral feature of an annuity can be relative to the taxable alternative.

Circumstances will vary, and tax rates may change, but under typical circumstances the advantages of tax deferral do not outweigh the annual costs of the annuity with the possible exception of those in the highest tax brackets and those with very high investment returns. And of course you cannot withdraw your money without penalty, and possibly adverse tax consequences, for a period of years.

Why has so much money has found its way into these products? Perhaps people don’t like taxes and look for ways to defer or eliminate them, even if the cost to do so outweighs the benefits. In addition, people may feel more comfortable with a guarantee that their initial contribution will be paid back in the event of death. They are also much more comfortable rebalancing their portfolios when taxes and transaction charges are removed from the decision. The decision not to rebalance a portfolio because of increased taxes may be more damaging than the taxes themselves. Finally, some of the money that has found its way into annuities was in liquid savings and wasn’t needed for emergencies, so the right financial comparison in this instance is the annuity return versus 1% in a savings account.

There are scenarios where owning a variable annuity makes a great deal of sense, even when comparing to a similar investment approach outside of the annuity.

Some products offer a guaranteed increase in value (often called a step-up), regardless of market performance, for a set number of years as long as that minimum value is converted to an income benefit. Let’s examine a 55 year-old buying a product with a guaranteed step-up of 6% per year and a guaranteed minimum income benefit (a rider available at an extra cost) of 5% at age 65. His $50,000 contribution is guaranteed to generate annual income of $4,477 at age 65 and he has received his premium back in annuity payments by the time he is 76 and 2 months. All future payments are those provided by interest and/or losses to the insurance carrier. If investment performance exceeds 6% after fees, he can receive higher payments and/or possibly leave a death benefit to his heirs.

If the annuitant lives to age 90, then the internal rate of return on this investment, assuming only the minimum income benefit and ignoring taxes, is approximately 3.9%. For some people that is a reasonable rate of return for an investment with the risks and benefits of an annuity. Some variable annuities offered step-up rates of 7% or more, and annuitization rates of 7%, before the financial crisis.

Those annuities have in all probability created losses for the insurance carriers and better sleep for the annuity holders.

Before purchasing a variable annuity, answer the following questions for yourself:

• Have I maximized my tax-preferential opportunities (401(k), IRA, etc.)?
  • Am I making a single contribution, or contributing over a period of years? (People who will be contributing over time may do better elsewhere)
  • Are step-ups and annuitization rates likely to yield increased distributions in retirement?
  • Am I going to change my investment risk because of an annuity?
    • Do I generally avoid the temptation of selling when investments have gone down and buying after they’ve already increased in value?
    • How long might I live and what will be my fixed sources of payments (e.g., Social Security and pensions)?
    • Do I understand all of the features and costs of the variable annuity being examined?

Conclusion

Weighing an annuity involves weighing risk, return, liquidity, tax-efficiency, and the strength of guarantees. Some individuals have done very well by putting money into annuities, better than they would have with an alternative. Every investment product tries to fill a specific need, it’s just a matter of whether the expense of the product can be justified by the performance and the financial security provided. The average variable annuity owner is going to receive less in benefits than a similarly invested alternative. This should be intuitive as insurance carriers are in business to make money.

If you are looking to accumulate the most after-tax money and aren’t in the highest tax bracket, you could be better off with taxable investments than a variable annuity. But if an annuity is a way for you to increase some investment risk, gives you confidence that you’ll continue to get a check as long as you live, or you value the opportunity to get an increase in your monthly check, a variable annuity can make sense.

Securities and Investment Advisory Services offered through NFP Securities, Inc., Member FINRA/SIPC. NFP Securities, Inc. is not affiliated with J Matrik Wealth Management. NFP Securities, Inc. does not provide legal or tax advice.

NOTE: Variable annuities are long-term investments designed for retirement purposes. In the Accumulation phase, they can help you build assets on a tax-deferred basis. In the Income phase, they can provide you with guaranteed income through standard or optional features. Variable annuities are subject to insurance related charges including mortality and expense charges, administrative fees, and the expenses associated with the underlying funds. Early withdrawals are subject to company-imposed surrender charges. Withdrawals are also subject to ordinary income tax, and if taken prior to age 59½, a 10% federal tax penalty may apply. Investment involves risk, including the possible loss of principal. Your contract value when redeemed may be worth more or less than your original investment.