Variable Annuities Punish Returns, Taxes and Heirs

— -- In these days of low bond yields, many people are looking for easy, set-it-and-forget-it investments to generate income. Stepping aggressively into this itchy market are insurance companies and their salesmen, extolling the supposed benefits of the variable annuities (VAs) they offer.

This type of annuity provides indirect investment in stock mutual funds. Yet this investment, long widely criticized by consumer-minded experts, is no better than it used to be. It ties up your capital, deprives your heirs (compared with direct market investment) and has major tax disadvantages.

Last month, Carlo DiFlorio, chief risk officer of the Financial Industry Regulatory Authority, said that VAs remain “one of the top products for consumer complaints,” many of them involving disclosure and sales practices.

This is hardly surprising, considering the consumerist adage accurately long assigned to these products: They are sold, not bought. If you’re middle-aged or older, and have a pulse and any accumulated wealth, there’s a good chance that someone’s tried to sell you a VA. The reason they try so hard to sell to you is that they earn huge commissions — from 5 to 8 percent — which would mean up to $40,000 for an afternoon’s work selling you a $500,000 annuity.

The idea is that you invest a lump sum that, in turn, the insurance company holding the annuity then invests in mutual funds, and your investment accumulates returns from these funds. At the end of the accumulation stage, the insurer guarantees a minimum payment and after that remaining income payments vary based on the performance of the stocks and bonds in the underlying portfolio.

Sometimes these salespeople tell investors that no commissions are involved. What they’re omitting is that they earn a big commission that comes from not from you directly, but from the insurance company. The insurer needs to recoup the sales commission out of the returns on your invested capital, so there’s a lock-up or accumulation period (usually five to seven years) during which investors pay a high penalty for early withdrawal.

And what about the net returns you get from your lump-sum investment (not the ones your money earns, but those that you get to keep)? They’re generally not good, compared to those you could get from investing in the market directly. And even if the returns were good, these investments would still carry so many downsides that it’s easy to make the case that this is the worst way to invest in the stock market. Among the disadvantages:

* High taxes for you or your heirs. VAs are marketed as being tax-deferred, but so are most other investments, including individual stocks, directly purchased mutual funds and exchange-traded funds, as long as you don’t cash them in. But when you cash in an annuity, you get hit with ordinary income tax (the top rate is now roughly 40 percent), as opposed to the maximum capital gains rate of 20 percent that you’d pay on these other investments. If you die, your heirs would pay ordinary income tax on the gain from the time you bought the annuity — on top of any estate tax.

* High costs. Insurance companies holding these investments charge annual administration fees of 2 to 4 percent. So it’s ironic that people currently seeking yield would be so motivated to buy a VA.

* Limited liquidity. This is an extremely long-term investment that either ties up a huge amount of your accumulated wealth or socks you with early withdrawal penalties.