I’ve written before about indexed annuities, one of the most expensive, abusive, unnecessary financial products known to man, but I’ve recently had a couple occasions to learn more about variable annuities, the confusingly-similarly-named product offered at lower cost by more reputable firms, like Vanguard and Fidelity.
Variable annuities are expensive
There are two expenses that go into a variable annuity: the wrap fee and the fee for the underlying funds your money is invested in.
For example, Vanguard charges 0.29% in annual administrative and “mortality and expense risk” fees, plus investment portfolio expense ratios ranging from 0.11% (Total International Stock Market Index Portfolio) to 0.42% (Growth Portfolio).
Meanwhile, Fidelity charges 0.25% in fees plus portfolio expense ratios between 0.10% (Fidelity VIP Index 500) and 1.54% (PIMCO VIT CommodityRealReturn Strategy).
Since you’re a sophisticated investor, say you combine the best of both worlds and invest only in the cheapest fund with each provider. You’ll pay 0.4% annually to invest in the total international stock market with Vanguard, and 0.35% annually to invest in the S&P 500 with Fidelity.
Is that a lot? Well, it’s over 3 times more expensive than buying Vanguard’s Total International Stock Index Fund Admiral Shares and almost 9 times more expensive than buying Vanguard 500 Admiral shares, but it’s not objectively very expensive, so if variable annuities offered tangible benefits, they wouldn’t have to be very valuable to make back that difference.
So, do they offer tangible benefits?
Variable annuities are not tax efficient
The first problem with variable annuities is they swap the extremely favorable tax treatment of capital gains and qualified dividends for the extremely unfavorable treatment of ordinary income. This happens in a fairly complicated way that I still don’t fully understand, but essentially withdrawals from variable annuities are done against an after-tax contribution portion (which is untaxed on withdrawal) and an earnings portion which is taxed as ordinary income, a bit like how non-qualified withdrawals from 529 plans work (except more complicated).
The advantage of this trade (capital gains for ordinary income) is theoretically that you can defer capital gains taxes during your high-earning years, when you might pay up to 23.8% on them, and then make withdrawals during your low-earning retirement years, when your marginal tax rate on ordinary income is lower.
If capital gains were taxed as ordinary income (as I would prefer), this argument would be airtight, and variable annuities would be a commonsense way to smooth your tax burden over a lifetime. People would use variable annuities instead of taxable brokerage accounts for all their savings in excess of qualified retirement accounts, paying less in capital gains taxes during their working years and more in ordinary income taxes during retirement.
The problem is that capital gains aren’t taxed as ordinary income: they’re taxed at preferential rates, and those preferential rates extend high up the income scale. The 23.8% rate I mentioned above is the highest rate paid on capital gains, while taxable income in excess of $82,500 is taxed at 24%, and rates only climb from there.
Between Social Security old age benefits and required minimum distributions from IRA’s and 401(k)’s, taking taxable withdrawals from a variable annuity can easily put someone’s taxable income in the range where they’re actually paying more on their gains than they would have if they’d simply held their investments in a taxable account and benefited from preferential capital gains tax treatment.
Variable annuities are terrible estate planning
When the owner of a taxable investment account dies, their heirs inherit their assets with a “stepped up” basis: the owner’s unrealized, untaxed capital gains receive a new, higher cost basis and those capital gains will never be taxed.
When a variable annuity is inherited, the account retains the distinction between contributions and earnings, and earnings will still be taxed on withdrawal at the heir’s ordinary income tax rate.
Heirs can either take a lump sum distribution of the account’s balance (potentially paying up to 37% of the earnings in taxes), or spread the distribution out over 5 years. In either case, rather than the owner saving money on taxes in retirement, the account’s gains are taxed at the likely higher tax rate of the inheritor.
The best case for variable annuities
I gather that I come across as a bit of a scold in this post, but I always try to find the good in everyone and in every financial product, so after a little bit of thinking, I came up with a perfectly reasonable use case for variable annuities.
Consider a high earner who knows she wants to retire early. Because she’s a high earner during her working years, she exclusively uses traditional IRA’s and 401(k)’s to reduce her taxable income. Likewise because she’s a high earner, she’ll pay 23.8% in taxes on any dividends and capital gains distributions during her working years for assets held in taxable accounts.
Instead, he contributes to variable annuities, perhaps splitting his contributions 50/50 between the lowest cost options at Vanguard and Fidelity (I don’t know why Fidelity doesn’t have a low-cost international stock portfolio. Or, rather, I do know why).
If she contributes, say, $50,000 per year to her variable annuities, compounding at 5% annually over 20 years, she’ll end up with $1.736 million, of which $1 million will be contributions and $736,000 will be earnings.
At age 59 1/2 (when variable annuity withdrawals become penalty-free), he gives two weeks notice and start withdrawing 9.1% of the balance per year, or $158,000, of which $91,000 will be tax-free contributions and $67,000 will be earnings taxed as ordinary income (this is not exactly how it works, but close enough). Assuming no other taxable income, he’d owe a nominal amount of tax on that amount.
Then, at age 70 she would file for her much higher Social Security old age benefit and at age 70 1/2 start collecting required minimum distributions from her traditional IRA and 401(k) accounts.
In other words, since delaying filing for Social Security is so lucrative, even someone retiring early should find a way to delay claiming their Social Security old age benefit as long as possible. If they have no earned income in retirement, then the relatively unfavorable tax treatment of variable annuity withdrawals is irrelevant, as long as their total taxes paid on withdrawals is lower than the capital gains tax payments they would have owed during their working years had the assets been held in a taxable account.