Gil’s Musings

Annuities: World’s Misunderstood Vehicle

With annuities boasting one of the most lucrative commissions in the investment sales world, you can imagine why meals at the local eatery while listening to the pitch are “free.” As a point of clarification, we don’t sell annuities, or any insurance product and can’t earn a commission of any type on anything.

But the free lunch ends at the local diner. There are situations for which an annuity provides a fine solution. One would be for a lottery payout. Another would be for a parent with a spendthrift adult child now being rationed. Still another would be a retiree with a savings cushion so slim that risk assets like stocks are unwise, but stocks inside an annuity might work well because the income is guaranteed even if the account exhausts itself. For the well-heeled, steer clear.

Annuities are often presented as being valuable by way of guarantees and tax deferral. But at what cost? There are two primary factors driving the disadvantages of annuities; high fees and high taxes. Traditional costs are problem number one. Annuity fees are often so high, they might consume the entirety of the original investment within a normal lifetime. And while there are cheap, no-commission annuities, don’t expect to hear about those from your Big Bank Broker or agent. But the problems don’t stop there. While taxes are deferred for a time, annuity earnings are always taxed at the highest applicable bracket: ordinary income. This is true of income withdrawn during one’s lifetime and taxes on increased value when left to an heir. Contrast that with owning a stock until the end of one’s life and then bequeathing it to an heir. The dividends earned during one’s lifetime would be taxed at a maximum of 23.8% and the capital gain in the value of the stock would be forgiven at the owner’s death, leaving your inheritor zero taxes owed. This tax forgiveness even applies to a surviving spouse. Stock portfolios can be constructed to defer tax on most gains with a tax-free cleansing of profits at the first and second deaths of a couple. Annuity tax deferral into an ordinary tax bracket of up to 38% seems onerous in comparison.

One of the most misunderstood components of many variable annuities occurs within those contracts containing an income benefit. The broker-speak used when explaining the accumulation details can lead to significant mismatches in what is said and what is heard. Because our brains are wired to hear information about returns as though we are earning interest, we think of returns in terms of credits to our account, like interest from a CD. A bank CD offering 2% is guaranteeing a credit of 2% plus your principal whether you take the income or the entire amount. When an annuity salesman says “it guarantees you 6%.” It doesn’t work the same way as a CD. That’s because you are usually being guaranteed only a 6% higher withdrawal privilege; OF YOUR OWN MONEY. They say “It credits you 6% Mr. Jones, in any year that you don’t take income.” YES, BUT IT’S FUNNY MONEY. They are merely crediting you a larger withdrawal benefit of your own money, and they are charging separate fees for that privilege and based on the set of books that provides the largest fee. That combination virtually assures the principal goes to the insurance company over time and the rationing is calculated so that you die before they are on the hook with a zero balance and income still due.


Virtually all variable annuities with an income benefit have two sets of books: The hypothetical pot that you cannot withdraw from, and the real money pot which own mutual funds. Imagine the confusion when the annuity is guaranteeing credits to your account, but only in the first set of books, on the “funny money.” To make matters worse, the fees are charged against the “higher of” the two sets of books. To illustrate, let’s look at Annuity Andy, who has $100,000 in savings and buys an annuity at age 70. With 3% annual fees in a generous 8% stock-return world, in Year 1 the real money pot rises at only 4.76% (not at 8-3=5%) because it was dinged for fees. The salesmen also tend to not mention that the 6% credits cannot be withdrawn, and they don’t compound.

table 1.JPG

In any year that the hypothetical money pot is larger than the real money pot after fees, the larger of the two drives the fee calculation. In Year 3 of this example, the $118,000 value below would drive the fee calculation, but the fees would be taken from the $114,970 pot.

table 2.JPG

This cost assignment methodology often makes the fees 20% higher than what is disclosed in the prospectus because of the term “higher of.” Compound and repeat this process and you will find the iceberg is quite large to begin with and even far bigger than you can see.

Also, you may notice in the chart above that the guaranteed 6% usually does not compound. Accordingly, in the first year you’d receive 6% ($6,000 on a $100,000 contract.) In the following year you’ll still receive $6,000, on a $106,000 value. That’s only a 5.66% return. You can see how this “guaranteed return” marches lower and lower. By Year 10 the “guaranteed return” is only 3.9%.

In any year that the market zooms higher and outpaces the hypothetical account, you get the higher of the two income calculations. But when you think about it, this drives the fees higher and the risk lower for the insurance company. They are truly not at any risk until the real money account is almost out of money, and the owner has aged a few years in the meantime, decreasing their risks further. It’s quite a goldmine.

All the income guarantee provides is a rationing of your own money at a particular rate, and the use of the word “guarantee,” “income,” and “return” probably are misleading when used in the same sentence. Reconsider the original tax issues presented above. Is tax deferral inside an annuity truly worth losing the tax-free step up available in stocks; especially when you consider the swap is for ordinary income taxation on all growth in the annuity eventually at twice the tax rate? This would only be worthwhile in the absolute lowest tax brackets, where very few “investors” reside. When you then consider the 5-10x higher costs inside the annuity, you will find that far more annuities are purchased than should be if we all understood the fine print.

Please See Important Disclosure Information

Subscribe to Gil’s Musings

Sign up to receive Gil’s periodic musings about investment trends, the stock market, investor behavior and current affairs. Join today and receive a handful of Gil’s favorite past musings, and be the first to receive his freshly penned thoughts

  • This field is for validation purposes and should be left unchanged.