In isolation, there's nothing wrong with a variable annuity (VA). Their benefits include tax-deferred growth, professional money management, numerous investment options, and a contingent death benefit. Severe deficiencies become apparent when VAs are compared to low cost, tax-efficient investment products such as index funds.
While the tax deferral feature of VAs is a benefit, it is a limited one compared to tax-efficient index funds, which typically retain 95% or more of their total return after taxes. The high expenses associated with VAs more than offset the modest tax savings, compared to index funds.
The biggest problem with VAs is upon withdrawal or death. All of the gain on a VA is taxed at the investor's marginal ordinary income tax rate, unlike stocks or mutual funds that are taxed at the lower capital gains rates. Upon death, stocks or mutual funds receive a step up in basis with no capital gain tax consequence to heirs. VAs don't receive a step up in basis and are subject to the full income tax on the gain.
Further, high cost basis "tax lots" of stocks or mutual funds can be selected for sale, minimizing capital gains tax. In contrast, most VA withdrawals are treated as first-in, last-out, meaning all withdrawals are subject to the investor's maximum marginal tax rate income, until all the gain has been withdrawn. The original principal deposits are not subject to tax, but are the last to be withdrawn for tax accounting purposes.
In addition to less favorable taxation, variable annuities are also very costly compared to index funds. The median expense for VAs is 2.01% versus .29% for Index Funds. Significant sales incentives are offered to VA salespeople - high commissions, bonuses, trips - and unlike mutual funds, they generally offer no discount on commissions for large transactions. When the sales commission feature is eliminated, sophisticated objective advisors simply won't recommend VAs to investors. An exception to this is if an investor already owns a high cost retail VA with a (substantial) gain. If client circumstances are appropriate, a high-cost retail annuity can be exchanged for a no-load, low-cost Institutional Variable Annuity, without incurring a taxable gain.
