Be Wary of Variable Annuities

The bear market has offered peddlers of variable annuities an ideal environment to sell their products. Over the past several months, who wouldn’t have wanted an investment that guarantees that you can’t lose? That’s the basic promise behind variable annuities and their newer cousins, equity-indexed annuities. If the markets go up, so does your annuity; if they go down, you can never get back less than your original premium. It sounds good, and sales agents push it, not least because annuity commissions are usually much more generous than they are on other sales an agent makes.

Adding to the allure for the investor is a tax-deferral feature. Money you put into these annuities and any earnings on that money are tax-free until you start to take money out. There are several drawbacks, however. One of the biggest is the surrender period, which almost all annuities have. During the surrender period, which can stretch up to 15 years, you’ll pay a hefty penalty if you take your cash out. For investors who need to tap into their nest eggs before the surrender period is up, this can be a major problem.

Over the long term, there are other downsides, including an average expense ratio of about 2.1%, compared to 1.4% for the average mutual fund and 0.2% for a penny-pinching index fund. Over time, the higher expense ratio can do serious damage to your investment results. And, unlike taxable mutual fund gains, which can be taxed at lower capital gains rates, money you take out of an annuity is taxed as ordinary income, with Uncle Sam taking as much as a 35% cut.

Tip: Ask the sales rep to tell you why an annuity is a good investment for you. It’s also not a bad idea to get the answer in writing.