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A variable annuity is an investment vehicle designed for
retirement savings. You may think of it as a wrapper around an underlying
investment, typically in a very restricted set of mutual funds. The selling
points of a variable annuity are that the underlying investments grow
tax-deferred, as in an IRA, and that when you retire, the annuity will pay you
an income, based on how well the underlying investment performed, for as long as
you live. Annuities are sold by insurance companies, and use an insurance policy
to provide the tax deferral. (Remember, tax deferral is not tax-free. It means
that taxes are delayed. That can be both good and bad.)

Unlike an IRA, the money you put into an annuity are not
deductible from your taxes. And also unlike an IRA, you may put as much money
into an annuity as you wish. But beware, because this may sound at first like a
good investment, annuities look pretty bad when you examine them in close
detail.

The following discussion compares an annuity to an index fund
(see also the article on index funds in the FAQ for misc.invest.mutual-funds).

Variable annuities are just about the worst investment
vehicle you can put your money into. They are extremely profitable for the
companies that sell them (which accounts for their popularity among sales
people), but are a terrible choice for you. You are much better off in an equity
index fund. Index funds are extremely tax efficient and provide, overall, a much
more favorable tax situation than an annuity.

The growth of an annuity is fully taxable as income, both to
you and your heirs. The growth of an index fund is taxable as capital gains to
you (which is good because capital gains taxes are always lower than ordinary
income) and subject to zero income tax to your heirs. This last point is
because upon inheritance the asset gets a "stepped up basis." In plain English,
the IRS treats the index fund as though your heirs just bought it at the value
it had when you died. This is a major tax advantage if you care about leaving
your wealth behind. (By contrast the IRS treats the annuity as though your heirs
just earned it; they must now pay income tax on it!)

If you remove some money from the index fund, the cost basis
may be the cost of your most recent purchase (or if the law is changed as the
administration currently recommends, the average cost of your index
investments). By contrast, any money you remove from an annuity is taxed at 100%
of its value until you bring the annuity’s value down to the size of what you
put in. (The law is more favorable for annuities purchased before 1982, but
that’s another can of worms.)

Tax considerations aside, the index fund is a better
investment. Try to find some annuities that outperformed the S&P 500 index over
the past ten or twenty years. Now, do you think you can pick which one(s) will
outperform the index over the next twenty years? I don’t.

Annuities usually have a sales load, usually have very high
expenses, and always have a charge for mortality insurance. The insurance
is virtually worthless because it only pays if your investment goes down AND you
die before you "annuitize". (More about that further on.) Simple term insurance
is cheaper and better if you need life insurance.

Annuities invest in funds that are difficult to analyze, and
for which independent reports, such as Morningstar, are not always available.

Annuity contracts are very difficult for the average investor
to read and understand. Personally, I don’t believe anyone should sign a
contract they don’t understand.

Annuities promise a guaranteed income for life. If you choose
to annuitize your contract (meaning take the guaranteed income for life), two
things happen. One is that you sacrifice your principal. When you die you leave
zero to your heirs. If you want to take cash out for any reason, you can’t. It
isn’t yours anymore. You have made the insurance company rich.

In exchange for giving all your money to the insurance
company, they promise to pay you a certain amount (either fixed or tied to
investment performance) for as long as you live. The problem is that the amount
they pay you is small. The very small payoff from annuitizing is the reason that
almost no one actually does it. If you’re considering an annuity, ask the
insurance company what percentage of customers ever annuitize. Ask what the
payoff is if you annuitize and you’ll see why. Compare their payoff to keeping
your principal and putting it into a ladder of U.S. Treasuries, or even tax-free
munis. Better yet, compare the payoff to a mortgage for the duration of your
expected lifespan. If you expect to live to 85, compare the payoff at age 70 to
a 15-year mortgage (with you as the lender).

For a fixed payout you would be better off putting your money
into US Treasuries and collecting the interest (and keeping the principal).

Now let’s consider a variable payout, determined by the
performance of your chosen investments. The problem here is the Assumed Interest
Rate (AIR), typically three or four percent. In plain English, the insurance
company skims off the first three to four percent of the growth of your
investments. They call that the AIR. Your monthly distribution only grows to the
extent that your investment grows MORE than the AIR. So if your investment
doesn’t grow, your monthly payment shrinks (by the AIR). If your investment
grows by the AIR, your monthly payment stays the same. When the market has a
down year, your monthly payment shrinks by the market loss plus the AIR.

If you do decide to go with an annuity, buy one from a mutual
fund company like T. Rowe Price or Vanguard. They have far superior products to
the annuities offered by insurance companies.

For more information about annuities, you might find these
articles helpful:

1. "Annuities: Just Say No" in the July/August 1996 issue of
   Worth magazine.

2. "Five Sad Variable Annuity Facts Your Salesman Won’t Tell
   You" in the April 5, 1995 Wall Street Journal quarterly review of mutual
   funds.

Just to be complete, note that there is such a thing as a
fixed annuity. A fixed annuity is a completely different animal from a variable
annuity, and is not very popular. The idea of a fixed annuity is that you give
money to an insurance company, and they promise to pay you a fixed monthly
amount for as long as you live. When considering a fixed annuity, compare the
annuity with a ladder of high-grade bonds that allow you to keep your principal.