The Ugly Math of Variable Annuities

| March 7, 2023 | 0 Comments

When a new client recently asked me to review a variable annuity they had purchased ten years ago, I knew I had my work cut out for me. Variable annuity contracts can be complex documents, loaded with confusing provisions, definitions, and terms. Often, the most complex parts are the most fundamental: the calculations used to determine the value of your “investment.”

A variable annuity is a contract between you and an insurance company. You agree to pay them some money today, and (typically) they agree to pay an income stream in the future. In between your premium payments and their distributions, the funds you put into the contract will typically be invested in sub-accounts that look a lot like mutual funds. That’s the basic structure, in a nutshell. Believe me, it gets a LOT more complicated.

This contract comes with expenses. Lots of them. First, there are annual fees for administration. This typically runs about 0.3 percent of the value of the annuity, and can also include annual fixed fees like $30 per year. Or both. There is also typically a “mortality and expense charge,” and may be other basic annual fees as well. According to, the average expense on a variable annuity contract is 2.3 percent and can be as high as 3 percent.

Typically, variable annuities also have surrender charges, which is a penalty imposed on your withdrawals if you pull money out of the contract before a certain date. Surrender charges are designed primarily to recoup the commission paid to the agent who sold the contract if you withdraw funds, so generally speaking, the higher the surrender charge, the higher the commission paid to the agent who sold you the contract. Surrender charges can last from five to ten years and can be as high as 10 percent in the first year of the annuity contract, declining over time.  

In addition to these expenses, you also have the costs of the underlying subaccounts. Like the mutual funds they are typically based on, there are the annual expenses of running these investment portfolios. These charges run the gamut, but typically range from as low as about 0.6 percent to more than 3 percent annually.

Finally, there are the cost of riders. These are additional options you can add to your contract. Without getting into the value or benefits of these options, they can be very expensive. They can also be tricky. Riders typically cost anywhere from 0.25 percent to 1.15 percent on top of the other expenses. In the case of my client’s annuity, they had two riders that were 0.95 percent each, but that 0.95 percent wasn’t calculated on the value of the annuity. It was calculated as a percentage of a HIGHER potential death benefit value. In effect, by the 10th year of the annuity contract, those fees were EACH actually about 1.4 percent of the value of the contract.

So, in this one example of a relatively average variable annuity, here is what my client was paying:

Contract charges:                              1.55 percent

Investment Expenses:                       1.04 percent

Riders:                                              2.80 percent

Total expenses:                                 5.38 percent

Frankly, I don’t know how you can invest successfully with 5.38 percent of your investment going to fees. After 10 years, my client’s annualized rate of return on his investment was just 1.4 percent per year for almost eleven years. After all this time, the guarantees inside the contract simply were not worth it. It would have been cheaper to buy a mutual fund and purchase a separate life insurance policy to make up for the guaranteed death benefit. The total cost would have been less and his investment results, though more volatile, would have been better.  

There can be a use for annuities as part of your savings and investment strategy. A fixed annuity can be used to replicate a pension, which is a predictable monthly income that lasts for as long as you do. However, variable annuities that combine investments and other complex add-ons are a poor choice for this. They typically deliver sub-par results at significant cost.

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/investment management with Blankinship & Foster, LLC, a wealth advisory firm specializing in financial planning and investment management for people preparing for retirement. Brooks can be reached at (858) 755-5166, or by email at Brooks and his family live in Mission Hills.


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