he magic of compound returns is overwhelmed by the tyranny of compounding costs.” That quote is from John Bogle, the father of the index investing strategy and the founder of The Vanguard Group. 

We’ve discussed the tyranny of fees and commissions in other posts. But perhaps the greatest of tyrannies comes in the form of one of the most popular types of investment vehicles being sold today: the Variable Annuity.

With these investments, you pay an insurance company a lump sum and the insurance company pays you regular payments. With an annuity though, your gains are taxed at ordinary income tax rates which are higher and more punitive than the capital gains rate. And, if you withdraw funds from your annuity before the age of 59.5 years, you’ll also pay a 10% penalty. Alternatively, you could have invested the same sum in the stock market and your investment gains would have been taxed at the favorable capital gains rate. So, with a variable annuity, you are taking investment earnings that would otherwise be treated as capital gains and converting them to earned income, which is taxed at a much higher rate than capital gains

This should be more than enough to steer you away from variable annuities, but it gets much worse. We haven’t even discussed fees yet. The typical variable annuity has sales commissions of 4%, management fees of 1%–2%, mortality risk fee of 1.25%, and insurance charges of 1%. After all these fees, you end up earning about 3%–4% per year. Not terribly impressive given that the market has delivered an average annual return of 10% for decades.

In short, annuities are low yielding assets, that are illiquid, have long surrender penalty periods and are taxed at punishing ordinary income rates. Additionally, annuities are highly complicated instruments and there is often limited disclosure so the investor does not generally understand all of the terms. The best policy is to steer clear or at least seek the advice of a professional who does not sell annuities before buying an annuity contract.