Simply put, a variable annuity is a portfolio of mutual fund like investments (called "sub-accounts") marketed to investors by insurance companies. However, it is important to make this point very clear: Variable annuities are designed for after-tax investing, not pre-tax retirement plan money. In short, retirement plan money, whether ORP/403(b) plans, corporate 401(k) plans, small business KEOGH plans, or the plethora of IRAs, should NEVER be invested in variable annuities. To put it in down home words, you don't feed a cow milk to produce milk.
Insurance agents, either through poor training and mentorship, ignorance, or greed, do not disclose to investors the limited use and true value of variable annuities. Rarely will the sales rep confess that the best use for a variable annuity is to provide a tax-deferred alternative to bank accounts, certificates of deposit, and money market accounts.
And since all retirement plans inherently provide tax-deferral, the use of a variable annuity in an already tax-deferred retirement plan money is redundant and inappropriate. In fact, in a perfect world, variable annuities should only be sold to high net worth individuals who are in the highest tax brackets in states with a state income tax.
Annuity Awareness
The first glaring weakness of a variable annuity is their high internal annual expenses, often twice that of the mutual funds companies such as Fidelity or Vanguard. Furthermore, high annual insurance expenses inherently erode the total return performance of any investment within the annuity. Also, unlike most mutual fund marketeers, insurance agents oversell variable annuities because annuities generally pay the agent a higher commission than mutual funds.
Moreover, annuities contractually do not offer investors "volume" commission discounts for larger money investors. And all thing being equal, higher commissions also have a direct inverse relationship to investment performance. It's a vicious circle that guarantees the insurance company and their sales reps reap big profits - at the expense of the annuity investment performance.
Second, variable annuities impose nasty surrender charges of anywhere from 5% to 10% of every contribution, sometime for as long as 15 years. Eventually, when an investor gets more sophisticated and wants to move their investment money to better performing, more cost-effective no-load mutual funds, the investor is saddled with the tough decision of paying a hefty surrender penalty - or leaving their money in a mediocre performing insurance annuity.
Third, and maybe most important, insurance annuity sales representatives don't want to "manage" annuity investments. Insurance agents only get paid when they sell the next annuity, not by taking care of existing clients by managing their annuity assets.
Unlike fee-only investment managers, insurance salespeople make all their sales commission right up front and are mostly "rewarded" for new sales. In most cases, this is a major conflict of interest for the hapless sales representative. To be fair, however, all commission-compensated investment salespeople - including brokerage house representatives - have the same conflict of interest.
In the end, insurance annuities are generally not the best prescription for your financial health and should be used sparingly. Bottom line: Annuities should only be used in specific situations.
Unfortunately, the insurance industry, regarding annuities, engages in vague marketing hyperbole and too good to be true promises to sell products that are not suitable for many trusting investors.
