7 Myths About Variable Annuities: Exposing Their Dark Side

One of the most misunderstood investment strategies I’ve come across over the past 29 years is the variable annuity. When I audit existing variable annuities, I get the facts about them by calling the insurance company directly rather than the broker who sold them. Why? Because I believe you should trust but verify, and I like to get my information directly from the horse’s mouth.

When I call the insurance company, among other questions, I ask: What are all the fees? What is the risk? What are the features? After going through that drill numerous times, I’ve pretty much seen it all. Based on my experiences over the past 29 years, the following are the seven most common myths I’ve learned about variable annuities and the facts dispelling those myths:

Myth #1: A variable annuity is a suitable investment for a retiree

I typically work with high-net worth clients, but regardless of your means, your investing goals and strategies evolve as you grow older.

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Early in life, you were probably happy to ride with the ebb and flow of the market, waiting and hoping to hit that investment “home run.” And why not? Suffering a loss now and then didn’t bother you because you were certain of a rebound, and you knew you had plenty of time to recover, long before retirement.

But years pass and investing approaches change. Entering retirement, most people start thinking about protecting and preserving what they have, not making a big splash in the market.

You may have heard it said that these days the return OF your principal is more important than the return ON your principal, and that is definitely true for most of our clients. That’s why the variable annuities some retirees count on for a regular income may not be the best route to take. Which brings us directly to Myth #2.

Myth #2: Your money is safe

People are often led to believe by their brokers that with variable annuities their money is safe, which couldn’t be further from the truth. Your money is invested in mutual funds with no real protection of your principal.

The name of the annuity pretty much sums it up: “Variable,” as in the principal varies, unlike a fixed annuity, where the principal is guaranteed by the insurance company and backed by their financial strength and claims paying ability.

In a variable annuity, your cash value is determined by how well the mutual funds perform, meaning it generally depends on the whims of the market.

Here’s an eye-opening exercise: Call your variable annuity insurance company’s customer service line and ask the representative what the cash value of your annuity was on October 12, 2007, and what it was worth on March 6, 2009. This shows you the value from the top of the market to the bottom of the market. Then you will know exactly how much you lost during the last major crash, and more importantly how much it has grown since March 2009. Hopefully you are well ahead of where you were in 2007 before the last crash, or at least breaking even at this point.

What if you purchased your variable annuity after 2009, and you enjoyed the bull market we had for over a decade since then? In that case, ask the insurance company what the value of your annuity was on February 19, 2020, and then again on March 23, 2020. This will show you how much you lost in that six-week COVID crash, which will give you an idea of how at-risk your principal is.

Albert Einstein is credited with saying, “The definition of insanity is doing the same thing over and over again and expecting a different result.” If your goals and needs have changed now that you are in retirement and are more concerned with preserving and protecting your wealth and keeping your fees low, then it might be a good time to change your retirement strategy to match your goals and needs.

Myth #3: Your fees are low

Variable annuities typically have high, hidden fees — ranging from 2% to 4% per year — that can eat away at your money, potentially leaving nothing for your beneficiaries and really dragging on your overall investment performance.

Variable annuities typically have up to five different fees! Again, you can call your variable annuity customer service line to ask what your specific fees are, which might include:

• Fee #1: Mortality and Expense (M&E) Fee
• Fee #2: Administration or Distribution Charge
• Fee #3: Mutual Fund Manager Expense (typically averages about 1%)
• Fee #4: Income Rider Fee, if applicable
• Fee #5: Death Benefit Rider Fee, if applicable

That’s a lot of fees! I have seen 4% annual fees on a regular basis in variable annuities that I audit for clients in my financial planning practice.

Myth #4: Your income rider value is your cash value

I have heard many clients say the broker told them money in a variable annuity is safe and can’t be lost. As I proved above, that’s just not the case, because your cash value goes up and down based on the mutual funds you’re invested in, minus the potentially high annual fees in the variable annuity.

What your broker is generally referring to is the addition of an income rider, which might grow at 6% a year. Some people believe they are earning 6% on their money, and that they can walk away with this lump sum 6% growth in the future. This couldn’t be further from the truth! If you think it about it logically, for the insurance company to pay you a 6% annual return, they would have to be earning approximately 9% a year to be able to pay you 6% and pay the broker a commission and still make a profit. Insurance companies typically earn closer to 5% per year because, by law, they must invest very conservatively in mostly corporate bonds. So, it just isn’t possible for them to pay you 6% and still have a profitable product.

What this really means is that only your income rider is growing at 6% per year, and if you want to walk away in the future with a lump sum of money, you aren’t getting the 6% per year growth income rider value. Instead, you will walk away with whatever your cash accumulation value is based on the mutual fund results, less the annual fees you paid each and every year.

The 6% rider simply says that at some point in the future, you can turn on a guaranteed pension for life and that if you outlive your money, the insurance company will continue to pay you that income for as long as you live. Sound good? Sure. But wait until you read the rest of the story…

Myth #5: Your income rider is an efficient way to receive income for life

Let me explain how an income rider really works using a hypothetical scenario. Let’s say you buy a variable annuity at age 65 from an insurance company for $1 million, and they might pay you 5% per year for life, or $50,000 per year for as long as you live starting immediately.

The good news is that this is a income for life, so even if you run out of money in the account, the insurance company will still pay you $50,000 per year for as long as you live. The bad news is that the $50,000 they are giving you comes out of your own $1 million. So, they are giving you your own money back!

What’s worse is that if your fees total 4% per year, or $40,000 in this case, they are charging you $40,000 per year to give you $50,000 of your own money. I don’t think it’s efficient to pay someone $40,000 per year for them to give you $50,000 of your own money, but that’s how this product typically works.

The really bad news is that if they are withdrawing $50,000 of your funds from your account (5%) and charging you $40,000 in fees (4%), that means each year you are withdrawing $90,000 from your account, or 9%! You must earn 9% per year just to have your cash value stay the same!

Now, you might have heard about the 4% withdrawal rule, which experts at Morningstar recently lowered to 3.3%. This rule of thumb states that you should take about 3.3% of your account value out each year to expect your retirement nest egg to last for your entire life. Clearly, taking 9% out of a volatile asset like a variable annuity might be difficult to achieve going forward.

Lastly, what happens if you have one or two bad years in the market and your principal loses 50%, going down to $500,000? The insurance company will still pay you $50,000 out of your money, and your fees might still be approximately $30,000. That means you are now withdrawing $80,000 out of your $500,000 each year, or 16% of your principal! It’s really challenging to have your money grow if you are taking 16% per year out of your money.

Myth #6: Your lifetime income will go up after you turn it on

Your adviser might have told you that your income could go up after you turn it on. Perhaps you looked at an illustration that showed if you bought the variable annuity in 1995 and immediately turned on your income, that income would have increased during that incredible bull market from 1995 to 2001.

But here’s the rest of the story: The only way to increase your income payout is if the market consistently earns more than the 9% you’re withdrawing each year in income and fees. While it’s possible that you might earn more than 9% year in and year out without having a losing year in the market, the odds are that starting from where we are in the stock market in mid-2022, it’s not very likely that you can count on consistently earning more than 9% per year without experiencing a down year.

Because of how this works, it’s much more likely there will be no increase for inflation in the future because you can’t really count on earning significantly more than 9% year in and year out. So, what will $50,000 actually buy in 10 or 20 years? If you’ve withdrawn all your principal in the variable annuity over that 20-year period, you won’t be able to reinvest that money in the future when we see opportunities to do so because that principal is gone.

Myth #7: Your family will always get the death benefit

Many people I come across have a death benefit rider, and they are under the impression their family will always receive the death benefit as a lump sum. But that often isn’t the case.

As we discussed above, withdrawing 9% per year from your variable annuity means that at some point during your lifetime you have a greater chance to run out of money in your account.

If you run out of money in your contract, the insurance company annuitizes the income rider value, which means they will continue to pay the $50,000 income to you, but the day you die, your family will no longer receive a lump sum death benefit.

This makes common sense. The insurance company can’t afford to give you $50,000 per year for as long as you live and pay your entire $1 million back to your beneficiaries if there is no money left in your account, right?

Some brokers have told my clients to just stop taking the $50,000 yearly income when the account reaches $1,000 in cash value to preserve the lump sum death benefit for their family. The problem with that idea is that the fees at that point might still be $20,000 per year. That’s because the insurance company charges their rider fees based upon the income rider value and the death benefit rider value, which might still be a $1 million rider value!

And many retirees wouldn’t want to stop taking $50,000 per year in income they live on to all of a sudden pay $20,000 per year to cover those rider fees! It’s just not often feasible.

So now that I’ve uncovered the seven myths about variable annuities and you have learned the facts about them, you can see why I generally don’t think they are a good option for a retiree – whether you’re a high-net worth client like the ones I meet with, who have over $1 million in investable assets, or someone with more modest savings to preserve. Retirement is the time to reap the benefits of your hard work. This not the time to take big risks, because in retirement, if you’re not careful, you can deplete your savings pretty quickly.

Our clients are looking to preserve and protect their wealth and leave a legacy to their family, and I believe that variable annuities aren’t in line with those goals.

To watch a full video about Variable Annuities from Craig Kirsner, MBA, go to Stuart Estate Planning’s YouTube channel.