Variable annuities are often sold as investments that provide market growth, tax-deferred earnings, and retirement income. The catch is that they’re often expensive, with restrictions and fees that can substantially erode returns.

Fees That Eat Into Returns

One of the biggest drawbacks of variable annuities is their layered fee structure. Investors pay several charges, including:

• Mortality and expense fees: typically around 1%- 1.5% per annum to cover insurance costs.
• Investment management fees: the fees associated with the underlying investment funds.
• Administrative fees: additional charges for keeping the contract.
• Optional Rider Fees: fees for features such as guaranteed lifetime income or enhanced death benefits.
• Surrender charges: the penalties you pay if you withdraw your money during the surrender period (which can be several years).

Combined annual fees can in fact run to over 3% depending on the contract and the optional benefits.

The Long-Term Impact of High Fees

Take a $500k investment earning 7% per annum before fees as an example. Over 20 years the investment with 0.50% in annual expenses would be worth approximately $1.76m. The same investment with 3% in annual expenses would be worth approximately $1.10m.

That’s over $660k lost as a result of the higher fees.

Tax Advantages Aren’t Always an Advantage

Variable annuities provide for tax deferred growth but withdrawals of earnings are typically taxed as ordinary income rather than at the lower long term capital gains rate. Unlike taxable brokerage investments they don’t get a step up in cost basis at death.

A Better Alternative?

For a lot of investors a portfolio of low cost ETFs, bonds and other liquid assets will be the way to go in terms of flexibility, cost and transparency. Depending on your own objectives your risk management strategy may well be a simpler way of dealing with financial volatility than an insurance contract. They also provide much greater clarity as to who owns the assets and how they are managed.

The Bottom Line

Variable annuities can be an option for an investor who requires insurance guarantees. The guarantees do come at a price though and so prior to buying one you should consider the total fees, the surrender charges, the tax implications and whether a simpler investment portfolio would actually be a better fit for your objectives.

The point isn’t just how much your investments make. It’s how much of that you actually keep.