Commentary: Variable Annuities: "The Fifth Best Option"

As baby boomers search for tax-sheltered ways to save for retirement and benefit from the runup of stock prices over the past few years, sales of variable annuities are flourishing. Last year, nearly $121 billion worth were sold, 10 times 1990's volume. But it's hard to make a case that variable annuities are a good buy.

Despite their popularity, variable annuities have a number of drawbacks, including steep fees, limited financial flexibility, and the transformation of low-tax capital gains into high-tax ordinary income. "They are the fifth-best option for retirement planning, behind everything else," says Ross Levin, president of Accredited Investors, an Edina (Minn.) financial-planning firm. So if you feel you must have one, focus only on those with the lowest expenses (table).

A variable annuity is essentially a mutual fund wrapped in a tax-deferred insurance firm account. Individuals buy variable annuities with after-tax dollars, but earnings compound tax-deferred until retirement, when any gains are taxed as ordinary income. Another part of variable annuities' appeal is their death benefit. When the owner of an annuity dies, the estate or beneficiary gets back the original investment, plus some guaranteed minimum return. So, if a variable-annuity owner invests $25,000 and dies when the investment shows a paper loss of $5,000, the estate or beneficiary still gets $25,000 and, depending on the contract, any guaranteed minimum return. If the owner dies during a bull market and the original $25,000 investment is worth $60,000, heirs get the $60,000.

While the death benefit is clearly comforting, it isn't worth anywhere near the price most insurers charge. A recent study by Moshe Arye Milevsky of Canada's York University and Steven Posner of Goldman Sachs concludes consumers are being charged as much as 5 to 10 times the economic value of the guarantee. A variable-annuity holder pays an annual fee for the death benefit, labeled the mortality and expense risk charge, or "M&E" fee. The average M&E fee last year was 1.14%, according to Variable Annuity Research & Data Service (VARDS) in Marietta, Ga. Morningstar, meanwhile, estimates the median M&E at 1.25% per annum. But how much is the death benefit really worth? Not much, says Milevsky.

SLIM ODDS. For one thing, the benefit probably doesn't make much sense for long-term investors. Market history suggests the odds are slim that the dollar value of an investment account will shrink over 10 to 30 years. For a more methodical and rigorous analysis, however, Milevsky and Posner use modern option-price theory and standard assumptions about such variables as interest rates and stock market volatility. Their estimate of the economic value of the death benefit appears in their study The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities. The study is available at

Their study says a typical 50-year-old male who buys a variable annuity with a simple return-of-premium guarantee should be charged a maximum of 3.5 basis points annually. As women live longer than men, a female buying a similar policy should pay only 2 basis points. A variable-annuity contract with a 4% interest-rate guarantee, which is obviously worth more, should charge a 50-year-old male 20 basis points and a 50-year-old female 12 basis points. That is about one-fifth to one-eighth the industry average for the M&E fee. Worse yet, companies typically tack on other fees. The average expense on a variable annuity is 2.23%, according to VARDS.

Since life insurers generally pay salespeople hefty commissions, most variable annuities carry surrender charges if you decide to bail out during the first several years of a contract. Surrender charges can be as high as 7% in the first year, 6% in the second, and so on during the first 5 to 10 years of the contract. And many salespeople persuade customers to place variable annuities in tax-deferred retirement accounts, a waste of the tax-shelter features of the insurance.

Many financial planners suggest consumers would be better off investing for retirement in a 401(k) or Roth IRA plan and putting any leftover cash in an equity mutual fund. For one thing, withdrawals from a variable annuity are treated as ordinary income, while some of any returns from a mutual fund may be taxed at the lower capital-gains rate. Indeed, many studies show that the breakeven point between investing in the equity account of a variable annuity and an equity mutual fund is between 15 and 25 years, a long time to lock yourself into one contract.

Anyone stuck in a high-fee product should consider a tax-free transfer of their money into a lower-cost alternative--assuming they're past any surrender charges. Vanguard Group, for example, offers variable annuities with no sales load or commission charges, an average expense ratio of 0.69%, and no surrender charges. Increased competition in the variable annuity business is bringing such thrifty alternatives about. But a lot more progress is needed.

Before it's here, it's on the Bloomberg Terminal.