Weigh the Aspects of Variable Annuities

Physician's Money Digest, May 15 2003, Volume 10, Issue 9

For a long time, variable annuities have beena hugely profitable best seller for insurancecompanies, in no small part because theyare generally so complex that most investors don'tunderstand even half of their pros and cons. Theymostly buy them because everyone wants to deferor avoid paying taxes, and annuities aresold as a way to do just that.


What's more, in the wake of themarket debacle, insurance companieshave been coming up with even morecomplex variable annuities that, on thesurface, seem to offer investors a "win-win"proposition that many investorsare finding irresistible. These annuitiesseem to guarantee an attractive minimumreturn over time, and if yourinvestment portfolio inside the variableannuity earns a higher return than theminimum guaranteed amount, thenyou get to keep the higher return. Howcan anyone resist such a proposition?

My opinion:

Probably 99% of theinvestors who buy variable annuitieswould be better off shunning them and investingtheir money differently. They may or may not betaking their small revenge on the government bypaying somewhat lower taxes, but that smallrevenge is probably costing them a lot more thanwhat they're saving.

Granted, I said 99% rather than 100% onlybecause I imagine someone somewhere may beable to come up with a special example of aninvestor who will be better off investing in a variableannuity instead of investing differently. But Ican't think of any such example unless someoneclaims that the many restrictions of an annuity willrestrain them from taking their retirement moneyout prematurely and spending it on somethingelse. If you knowingly want to pay a lot of moneyto impose such discipline on yourself, you mayrightfully belong in that remaining 1%.I can't imagine that would be the motivationfor too many people.


It's not very worthwhile to considervariable annuities as an investmentvehicle. As a physician-investor, it'shelpful to take a brief look at annuities'problems, so that you'rewell prepared to avoidinsurance companies' variousrecruiting tactics.

First, most variableannuities, especially theones that agents activelysell to you—as opposed tothe low-cost types that youhave to ferret out yourself—have high built-incosts, a lot of which is not easy to findout unless you make a special effort.Over the years, these costs will drainaway a big part of your returns. Most of thesereturns will end up in the pockets of the agents, theinsurance companies, and the fund managers. Is itany wonder, then, that they are all so keen to sellyou these annuities?

Second, there are all kinds of restrictions ongetting your money out from an annuity in the first5 to 10 years or before you're age 59½ in case youneed it for an emergency. In addition, you'rerestricted to investing the money in a particular listof funds. The list is often impressively long, but thefunds tend to be uniformly poor choices.

Third, the claimed tax savings, which are theprimary selling point for variable annuities, may bedubious. It is true that you can defer all taxes untilyou start withdrawing money from the annuity.However, when you start withdrawing, you'll payhigher ordinary income taxes as opposed to lowercapital gains taxes on all your gains.


Consider the alternative of regularly investingyour savings in a total market index fund and justholding on to it. Even if you hold it ina taxable account, over the years youwill pay ordinary income taxes onlyon the dividend distributions, whichare likely to be small. Such a fund willmake very little capital gains distributionsover the years. Therefore, all thecapital gains will accumulate tax-deferreduntil you start withdrawingthe money. When you do withdrawfunds, you will pay taxes on the capitalgains portion of the withdrawals atthe low long-term capital gains rate.

You may also be able to pass onmost of your investment in such a fund to yourheirs without either you or your heirs ever payingany capital gains taxes on the capital gains. Youcan't do that with an annuity.

And how about those new "win-win" policies?If you believe that's what they really are, you probablyalso believe in Santa Claus. By a certain age,we all have to grow out of such fantasies.

Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001), currently teaches finance at theFordham UniversityGraduate School ofBusiness and consultswith individuals onfinancial planning andinvestment management.He welcomesquestions or commentsat chandansen@aol.com.