How to Analyze a Variable Annuity(2)

How to Analyze a Variable Annuity

Ever had a variable annuity pitched to you?  Maybe you own one.  They’re a popular way for many people to mix guaranteed retirement income with the growth potential of equities.

But I’m guessing even if you hold a variable annuity, you’re not 100% sure how it works.

“What are the annual fees again?”

“How does that bonus period work?”

These were a few of the questions a client asked me recently when he was considering a variable annuity.

**Full disclosure – I do not sell variable annuities** 

This client just wanted a second opinion. He’d recently met with an advisor who pitched him a variable annuity, and wanted input from an objective source.

My client was in a tough position.  He’d just lost his father, and was about to receive a sizable inheritance.  He wanted to use this inheritance to produce income throughout retirement, since he was about to turn 60.

He was skeptical about investing in the markets, fearing that another financial crisis would destroy his nest egg.  At the same time, he struggled with the idea of buying an annuity.  He was attached emotionally to the money since it was coming from his father’s estate, and he didn’t want to fork it over to an insurance company.  On top of that, the annuity he was considering was complicated and confusing, and he was feeling a little lost.

After walking through everything together, my client decided to use some of his inheritance to purchase an annuity – but not the one he was being pitched.  He opted for a fixed rather than a variable annuity, which he bought with a small portion of the money from his father.  He decided to invest the majority of the money in a diversified portfolio geared to produce income.

My client isn’t alone, and I get a lot of questions about variable annuities.  Since they have so many moving parts, I wanted to share exactly how I analyze variable annuities using my client’s contract as an example.

There’s a lot of nonsense floating around the internet when it comes to annuities.  Hopefully this framework is useful to you if you’re considering buying one.


American Legacy Annuity Analysis

In this video, I’ll analyze the American Legacy variable annuity offered by Lincoln Financial Group, which my client was considering.  This specific contract is the American Legacy Shareholder’s Advantage annuity, with the i4LIFE Advantage Guaranteed Income Benefit.  I’ll also assume that the Enhanced Guaranteed Minimum Death Benefit (EGMDB) is chosen.

Framework: How a Variable Annuity Works

Before we discuss how to analyze a variable annuity, let’s take a step back and review how they work & where they came from.

Variable annuities have become very popular in the retirement planning industry over the last 25 years.  Essentially, they’re a contract between you and an insurance company that guarantee you a series of payments at some point in the future.

There are two phases in a variable annuity: the accumulation phase and the payout phase.  What’s unique about a variable annuity is that you invest your contributions during accumulation phase – hence the term “variable.”  These investments are known as sub accounts and behave a lot like mutual funds.  They are professionally managed and will follow a specific investment strategy described in a prospectus.

Your account balance in the contract will fluctuate over time based on the performance of these investments.  Then when you decide to begin withdrawing from the annuity the accumulation phase ends and the payout phase begins.  The income payments you’ll receive during the payout phase will depend on your account balance at the end of the accumulation phase.

Whereas a fixed annuity will pay you a stated rate of interest and income, the payout of a variable annuity depends on the performance of your sub accounts.

Most contracts will give you several options related to how you’ll receive payouts.  You might have the choice to receive a guaranteed income for the rest of your life or for the rest of you and your spouse’s lives.

You may also have the option of receiving payouts over a certain period, like 10 or 20 years.  In “period certain” contracts, your beneficiaries will continue to receive income for the specified period – even if you die before it’s over.



Variable annuities come in all shapes and sizes.  They also allow you pick and choose the features you want through riders and other options.

In the marketplace today, most riders you’ll find have to do with guaranteed lifetime income or a guaranteed death benefit.  Other options might offer long term care coverage in addition to income benefits.


Why Variable Annuities are Popular

Variable annuities have gained a lot of traction over the last 25 years.  First, they combine growth potential with guaranteed lifetime income.  This is really popular with retirees seeking a simple, all in one type of solution.

They’re also popular because they provide tax deferred growth.  Any gains realized in a variable annuity’s sub accounts are deferred until you withdraw from the policy, making them popular for retirement planning.  When do you take withdrawals, you calculate an exclusion ratio to determine how much of your withdrawals are taxable.

For example, let’s say you contribute $100,000 of taxable income to a variable annuity.  10 years later you start withdrawing from the annuity after you retire, when the account value is $150,000.  Two thirds of each of your withdrawals ($100,000 / $150,000) is considered a tax-free return of basis.  The other third is considered taxable income.  If you took out $1,000 per month, you’d only pay income tax on $333 of each withdrawal.


Lucrative Products

Variable annuities are also popular because they’re big revenue engines for insurance companies and professionals who sell them.

The financial industry has evolved a sales mentality.  Financial professionals have historically been trained as salesmen taught to push products, rather than as true advisors taught to consult with their clients.  And while the vast majority of financial advisors today are honest and trustworthy, most come from a sales (not a consultative) background.

Additionally, variable annuities generate massive commissions for advisors and agents – sometimes as high as 9% of their purchase price.  They also generate annual fees of upwards of 3% per year for insurance companies, making them a very lucrative product for both salesmen and employers.

In my opinion, variable annuities are popular today because they enrich financial salespeople and institutions – not because they’re great products.  Many financial advisors are taught and incentivized to push them since they’ll earn an advisor the biggest commission check.  Variable annuities didn’t become popular on their own merits.

If you’re being pitched an annuity, be sure you understand why your advisor might be recommending a certain product.  If you’re not sure, here’s a guide to help you evaluate your advisor.

By and large, the vast majority of financial advisors in the U.S. are good people who do good things for their clients.  But when it comes to annuities, it’s not hard for a fat commission check to influence an advisor’s thought process.  Make sure yours is acting objectively and in your best interests.


How to Analyze a Variable Annuity

When you’re analyzing an annuity, there are only two things that matter:

  1. How much money you put in versus how much you get out
  2. Whether or not your income is guaranteed

Bonuses, step ups, enhanced withdrawals, and other features might sound fancy.  But none of these make the least bit of difference on their own.

For example, annuity A might be guaranteed to appreciate 5% per year.  Annuity B might offer a 7% guaranteed appreciation.  Annuity B might clearly seem like the better option.

But what if annuity A also offered a guaranteed lifetime income of 5% of your account balance, while annuity B only offered 3%?  Which is the better contract?

All that matters is how much you put into a policy, how much you get out, and whether or not that income is guaranteed.

Here’s the framework I use to analyze variable annuities:


1) Understand the Features

The first step to analyzing a variable annuity is to understand the features of the policy.  This is especially important since variable annuities come in all shapes and sizes, with all sorts of different features and options.

You can find this information in the policy’s prospectus.  Unfortunately, prospectuses for variable annuities tend to come in very small print and be long and dense documents.  You’ll be glad to hear that you don’t need to read it cover to cover though.  Here’s what to look for:

  • Options & Riders: Most variable annuities will lump all their riders and options into the same prospectus document.  Sift through to find the option you’re considering, and make sure you understand all the ins and outs of the policy:
    • What happens during the accumulation period?
    • How is my account value determined?
    • Is there a death benefit?
    • What are my annuitization options when I decide to start taking withdrawals?
  • Bonuses: These will often be a big part of an advisor’s sales pitch, so be sure to check them out in the prospectus.  They’re also an important component when modeling annuities, which we’ll cover shortly.
  • Benefit Base:  A benefit base might be used along with some kind of bonus or guaranteed appreciation.  Usually a benefit base is compared to your account value, and when you decide to begin your payout period your income payments are based on the greater of the two.
    • For example, you might buy a variable annuity for $100,000 that guarantees a 7% minimum appreciation bonus.  Your starting account value and benefit base would be $100,000.
    • After one year, your account value would be based on the performance on your sub accounts.  Your benefit base would be $107,000, since it goes up 7% each year.
    • When you decide to annuitize the contract (or begin the payout period), your annual income benefit is be based on which amount is higher.
  • Withdrawal Rates: Most annuities with lifetime income riders will offer guaranteed withdrawal rates that differ by age.  You might be guaranteed 4% of your account value each year if you begin withdrawals at age 60, but 5% if you wait until age 65.
  • Annuitization Choices: When you make the transition from the accumulation period to the payout period, you’ll have some choices.  You’ll have the option to annuitize the contract, take withdrawals from the contract without annuitizing, or surrender the contract altogether.  Since variable annuity policies can differ quite a bit, be sure you understand your options before buying a policy.


2) Assess the Fees

The biggest drawback of variable annuities is the fees involved.  Depending on the policy and the riders you select, annual fees can total anywhere from 1.5% to 3% or more.  Even though variable annuities are designed partially as a growth vehicle, the annual fees are a huge drag on any potential account growth.

Mortality & Expense Risk: This is the core expense you’ll see in a variable annuity contract.  Any time an insurance company offers you guaranteed income for life, it’s taking on the risk that you’ll outlive your life expectancy.  Even though not all variable annuities offer guaranteed lifetime income, this risk is lumped into a Mortality & Expense Risk charge.  Usually this is expressed as a percentage of the account value, and is somewhere near 1% – 1.25% per year.

Administrative: Variable annuities also have administrative fees that they pass on to policyholders.  This is to compensate the insurer for expenses like record keeping and mailing out prospectuses.  These fees can either be a flat dollar amount or a percentage of the contract’s value, and are normally minimal.

Fund Expenses: Each of the sub accounts that you choose within a policy has an annual operating expense.  This is to compensate the investment manager operating the fund.  Fund expenses are a percentage of the assets managed, and can range anywhere from 0.25% to 1.75% per year.

Additional Riders:  Fees for these riders are normally expressed as a percentage of the contract’s value, but will vary widely.  They’ll also depend on how advantageous the rider is for policyholders.

Surrender Charges: If you withdraw money from a variable annuity within a certain period, there is usually a surrender charge assessed by the insurance company.  In most cases, surrender charges are pretty high to begin with, but decline over the first few years and eventually phase out entirely.  Usually this phase out happens within 6-8 years, but there are a few contracts that stretch surrender charges to 10 years from purchase.


3) Model It

My motto when analyzing an annuity:  When in doubt, model it out!

There are a ton of moving parts to variable annuities – so many that it’s impossible keep track of them simultaneously.

So to get an accurate representation of how an annuity will work over time, I always prefer building a model.  Much like an amortization table on a mortgage, this helps me understand exactly how the annuity functions and how various decisions will impact my clients.

The video above is a good example of how I use spreadsheets to build annuity models.


4) Compare Investment Performance

Part of why I like modeling so much is that it helps me and clients explore all possible options.  And remember, when you own a variable annuity you’re never required to hold on to it.  You can always surrender the policy and invest the proceeds if that’s a better option for you.

When building annuity models, I always include this option for comparison purposes.  Even though there might be a surrender charge attached, sometimes it’s better to get out of a poor contract or exchange it for something better.  Modeling helps us understand how this might look.


5) Make an Informed Decision

All in all, variable annuities can work for some people…..they’re just terribly expensive.  My philosophy is to model and compare all the potential options.  This way we can fully understand whether it’s better to buy, surrender, or keep a variable annuity.

Everyone has different long term financial goals, and to make an informed decision you need to fully understand how a specific product might fit into your plan.

When in doubt, model it out!


Some Considerations When Analyzing a Variable Annuity:

1) Annuities generate very large commissions for salespeople.  Variable annuities pay advisors up to 9% of the amount you put into a policy.  Unfortunately, this drives many advisors to make annuity recommendations based on their own compensation rather than an unbiased analysis.  If someone recommends a variable annuity to you, be sure to ask lots of questions and do homework on your own.

2) New is not necessarily better.  Just because there’s a flashy new product out there with huge bonuses doesn’t mean its a good idea for you to swap your existing product out.  Always research the details of what you’d be getting vs. what you’d be giving up.  Remember, bonuses don’t mean anything in isolation.

3) Don’t let salespeople use scare tactics.  Many retirees opt for annuities because their advisor scares them into thinking they’ll lose their life savings if the market crashes and they don’t have a guaranteed income product.  Don’t let this be you.  Even though it’s more risky to draw income from a non-guaranteed investment portfolio, there are thousands of low risk investment options available.  A good advisor can build a portfolio that matches your risk and income needs without handing your nest egg to an insurance company.

4) Annuities can be great for many, but they’re incredibly expensive.  Always do your homework and know what you’re getting into.


If You Have Questions About Annuities

If you still have questions about annuities and whether they’re right for you, feel free to reach out.

Just fill out the form below, and I’d be happy to point you in the right direction.

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  1. I’m often to blogging and i truly appreciate your content.
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    • Hi Meghan, thanks for your interest! Glad to hear you like the content. Feel free to reach out if there’s anything specific you’d like to see on the site.

  2. Why does Ken Fisher scream on his television commercials “I’d rather die and go to hell than sell an annuity”?

    • Hah! Because he’s trying to grab attention, and saying something outlandish like that grabs eyeballs. He’s built quite a business as an “annuity hater” though. While I agree that annuities are typically poor choices for investors, there are some circumstances where they can make sense.

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