Variable Annuities: The Devil's In The Details (May 2007)

Created on Tuesday, 01 May 2007 Written by Dominick Paoloni

Sales of variable annuities have exploded in the last several years, topping over $133 billion dollars in 2005. The reason for this dramatic increase in consumer purchasing has to do with a contract feature termed the Guaranteed for Life Withdrawal Benefit (GLWB)—common in most current variable annuity policies. The GLWB is touted by salespeople as a solution to obtain a retirement income for life.

The GLWB rider guarantees the VA policyholder an amount of money for life while still being invested in mutual fund sub-accounts (an important item to note is that withdrawals are not coming out of interest; the money is drawing from principal).

This GLWB feature still allows the policyholders to access their account value if needed and does not force the policyholder to give up access through annuitization. However, I find this caveat a bit disingenuous—if the sub-account value drops because of poor market conditions and the policyholder needs to withdraw from the account for emergencies above the 5% to 7% allowed through the GLWB contract feature, then he or she will destroy the income stream. In effect the client becomes trapped into not touching principal, which is, of course, preferred by the insurance company.

Examining the Costs

Most annuities with the GLWB offer an income stream that start out with a 5% payout to age 65 and increase this amount if the payout begins at an older age. The GLWB rider has an average cost of approximately 0.25% to 0.65% a year.

The insurance company states the GLWB can give investors 5% to 7% per year of their money back and guarantee them never to run out if the investments inside the variable annuity perform poorly. Yet this protection comes with a cost like all insurance does.

To illustrate how nothing in life is free, a client recently told me she wanted a reverse mortgage on her home because it would grant her income for life even if she exceeds the value of her home. I told her she was paying insurance for that risk—the mortgage company isn’t giving anything away. The question need to ask is whether the fees, costs and commissions embedded in the product—regardless of what it is—are value-added?

According to the National Association of Variable Annuities' (NAVA's) 2005 Annuity Fact Book, fees vary in variable annuity sub-accounts. The averages range from 0.623% for money market funds to 2.3% for bear market domestic stock funds, putting the average mean cost of mutual fund sub-accounts inside VAs at 1.415%.

According to Morningstar data through the second quarter of 2005, on top of the mutual fund costs in a variable annuity contract, the average cost of mortality and expenses averaged an additional 1.211% to the client. This includes insurance charges and basic death benefit guarantees.

If we add these fees together the total cost of the contract would be 2.626% (1.415+1.211) to the investor.

Armed with this information, when we add the mean cost of 0.45% for the GLWB rider, investors are paying 3.07% per year eating into their return. Again, does this cost justify the investment’s value and are the benefits received from a variable annuity worth that cost?

Do the Expenses Add Value?

To answer that question we must examine the sub-accounts available inside variable annuity portfolios. Out of 1291 Variable Policies consisting of 61,324 sub accounts in the Morningstar database, there are 19 distinct mangers (funds) that meet my criteria justifying their cost against the value they deliver.

At first glance 19 value added mangers don’t sound too bad. To build a well diversified portfolio IPS uses between 7 to 16 value-added managers across our three portfolios; however, because variable annuities only allow the investor to work within the subaccounts in the policy, I couldn’t find any one policy with more then three value add manager and most policies contained zero to one manager. This means you simply can’t build a valued-added asset allocation model inside a variable annuity that is cost-justified.

For example, even if you used a good small cap, emerging markets, and real estate manager in an account, you could still not create true diversification, regardless of how strong the managers are.

So in variable annuities you’re paying active management costs with a portfolio that can’t even keep up with the indexes in which they are invested. As Scott Burns points out in his July 2006 article in Uexpress, “…the homely index fund, after all taxes are paid, would have ranked 10th against 178 managed (variable annuity sub- account) contenders.”

In conclusion you are paying for a GLWB rider to guarantee an income flow that you wouldn’t need if you simply had better risk/return asset models in a self-directed investment account.

Given this evidence, why do investors purchase variable annuities with such fervor? Recently a brokerage firm manager spoke to this issue in a discussion we had about the mounting variable annuity sales in her office. She explained that a mutual fund wholesaler was visiting her office to discuss other products like a well-diversified asset allocation model of mutual funds—her brokers didn’t want to learn the complexities of asset allocation modeling and they found variable annuities to be much easier to sell and oversee. I politely told her she was being naïve—I believe the reason her brokers were recommending variable annuities was because of the huge commissions they generate. She disagreed.

In addition to the perceived benefit that the GLWB income stream variable annuities supposedly offer investors, what other benefits do salespeople offer to convince consumers to make a purchase? Variable annuity advocates argue that compounding tax deferrals help justify the cost of this investment type. The problem is that variable annuities do not receive the advantages of long-term capital gains and qualified dividend rates and therefore any tax deferrals are negated. What’s more, assets that are already tax-deferred certainly wouldn’t benefit inside a variable annuity, though I often see poor planning in this regard with brokers placing IRA assets inside a variable contract.

Research demonstrates that variable annuities do not “live up to the hype” and that their increased costs do not justify their value to investors.


As Scott Burns points out in his July 2003 article, “It’s The Expense That Makes Variable Annuities Bad,” “My beef with variable annuities isn't personal. It's the math. The primary flaw of variable annuities is that the cost of the product exceeds the value of its tax deferral.”

Although variable annuities are advertised and promoted to provide a safe investment alternative that can provide growth, safety & liquidity to investors (the “3 magic words” in financial planning), upon further inspection we find that they actually offer none of them. Helping clients understand the hidden pitfalls and inefficiencies in this investment strategy is both prudent and necessary. As Richard Nixon once said, the devil’s in the details. With variable annuities, truer words were never spoken.


Lankford, Kimberly, The Great Annuity Rip-Off (Kiplinger’s Personal Finance, January 1, 2007).

Hoffman, Ellen, Don’t Believe the Hype (Business Week: February 7, 2005).

Hoffman, Ellen, Don’t Believe the Hype (Business Week: February 7, 2005) This mean is calculated based on information from the Business Week article, “Don’t Believe the Hype.”

I screen all mutual funds using at least four key criteria: management tenure greater than at least 3 years, best-fit alpha greater than 3.07%, (the average cost of carrying a variable annuity), best-fit correlation coefficient (R2) greater than 90 (documenting the manager is truly showing added value in his/her specified asset class) and an informational ratio that is positive (this data point documents how consistently the manager is able to deliver positive alpha).

Burns, Scott, Index Fund Wins Race Against Variable Annuity Stable (uExpress: July 9, 2006).

Burns, Scott It’s The Expenses That Make Variable Annuities Bad (uExpress: July 31, 2003).

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.