If something genuinely bad happens, the blanky doesn’t do anything.
This is the honest description of what a variable annuity is for most of the people we see holding them. A source of psychological comfort that costs 3% a year, doesn’t do what the holder thinks it does, and happens to pay whoever sold it a commission that would make a used-car salesman blush.
This take is pretty common among fiduciary advisors, by the way. What’s less common, and what makes the product so widespread, is that the people selling variable annuities aren’t generally fiduciaries. They’re commission-based brokers and insurance agents using the title “financial advisor” because the title isn’t regulated. The product gets sold hard because the people selling it earn a living that way.
Here’s what the product actually looks like once you take it apart.
What You’re Actually Paying
A variable annuity is a bundle of three things: a brokerage-style investment account (the “sub-accounts”), an insurance contract wrapped around it, and whatever riders were sold with it. Each piece costs money.
The M&E charge (mortality and expense) is typically 1.00% to 1.40% annually. That’s the cost of the insurance wrapper itself. The sub-account fees on the underlying investments are usually another 0.75% to 1.50% on top of that, depending on what’s inside. If the contract came with a living benefit rider (GLWB, GMIB, variations), add another 1.00% to 1.50%. There’s usually an administrative charge on top.
Total all-in cost on a typical variable annuity with a living benefit rider: somewhere between 2.75% and 4% per year. Every year. Whether the market is up or down.
For comparison, a diversified portfolio built with low-cost funds inside a brokerage account typically runs 0.50% to 1.25% all-in, including advisor fees for clients working with a fiduciary.
Over twenty years, the compounding difference on a $1M portfolio between 1% and 3.5% in annual costs is in the hundreds of thousands of dollars. This is not a footnote. This is the point.
What The “Guarantee” Actually Guarantees
The feature that gets variable annuities sold is usually the living benefit rider, some version of “guaranteed income” or “guaranteed account value” or “downside protection.” The brochures show a chart where your money can’t go down, which is a very appealing chart when the market is going down.
Here’s what the rider usually actually does:
It guarantees an “income base,” which is a phantom number used to calculate your future withdrawals, not your actual account value. Your actual account value can and does drop. If you ever surrender the contract, you get the actual account value, minus surrender charges, not the income base.
The income base typically grows at a guaranteed rate (often 5% to 6%) during an accumulation phase, but only if you don’t take withdrawals. And the rate applies to the income base, not to your money.
The guaranteed withdrawal percentage – the amount you can pull out each year as “lifetime income,” is often 4% to 5% of the income base. A diversified portfolio with a reasonable withdrawal strategy supports similar withdrawal rates over a retirement without the 3% annual drag.
The “guarantee,” stripped of the marketing, usually amounts to: pay us a lot of money every year, and if the market crashes badly enough for long enough that a reasonable withdrawal strategy would have failed, we’ll cover the difference. For most people, that’s insurance against an event that doesn’t happen, purchased at a price that makes the event that does happen, inflation eroding returns over decades, much more likely.
Why These Get Sold So Hard
Commission on a variable annuity sale can run as high as 7% to 9% of the contract value, with some structures pushing even higher. On a $500,000 purchase, that’s $35,000 to $45,000 to the salesperson on day one, funded by the surrender charge schedule the buyer is now locked into for the next six to eight years.
For context, a fee-only fiduciary managing the same $500,000 in a diversified portfolio would earn a fraction of that in the first year and would earn it only if the client stays. The incentive structures are not comparable, and they produce non-comparable advice.
There are some very narrow cases where a variable annuity may make sense. We’re not going to get into those here.
What To Do If You’re Already Holding One
Don’t surrender it in a panic. Surrender charges are real and may make exit more expensive than staying.
Do get a second opinion from an advisor with no stake in what happens next. A fee-only fiduciary can analyze the contract – the riders, the surrender schedule, the cost-benefit of staying versus alternatives, including lower-cost fee-based structures that exist in the market. There are options the person who originally sold you the product likely never mentioned, for the same reason they never mentioned the commission.
A comforting product that costs 3% a year for thirty years is not a neutral decision. It’s one of the largest drags on long-term wealth we see, and it’s worth the afternoon it takes to understand what you actually own.
A blanky is fine for a child. For an adult with a balance sheet, a real strategy costs less and does more.