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8 Reasons Why You Should Invest With Mutual Funds Instead Of A Variable Annuity

Savannah Headstones

Today’s Saturday Selection is a classic post from The White Coat Investor. In the post, he outlines the numerous ways investing in plain old mutual funds beats a variable annuity.

I obviously agree with the good doctor. Half of my investments are in passive index funds in a taxable account. Zero percent of my nest egg is tied up in a variable annuity, or any type of life insurance product for that matter.

As per usual, this post originally appeared at the WCI network partner site The White Coat Investor.

Variable annuities (VA) are an insurance product that is best described as a mutual fund wrapped in an insurance wrapper and covered with fees.  They have several advantages over mutual funds (in a fully taxable brokerage account), including tax-deferred earnings, some protection against creditors, and tax-free buying and selling within the account.

But no reasonable person would argue that investing in a VA is a smarter move than investing in an IRA, Roth IRA, or 401K.  However, it isn’t uncommon to hear arguments that “a doctor in a high tax bracket should invest in a VA instead of in mutual funds in a taxable account.”  That argument, of course, is almost always made by someone who sells VAs for a living.  Here are the problems with that argument.


1) Variable Annuity Withdrawals Taxed at Ordinary Income Tax Rates

If the chief upside of investing in a VA is tax-deferred growth (i.e. the investment isn’t taxed each year on its capital gains and dividends), then the chief downside is that when you pull the money out it is taxed at your ordinary income tax rates rather than the lower capital gains/dividends rates a mutual fund would get.

Consider two investments with the exact same after-fee return (stop laughing and just IMAGINE for a minute).  One is a mutual fund and the other a VA.  How long would it take before the benefit of the tax-deferral would make up for the lower tax rate at withdrawal?  Let’s assume a 33% tax bracket, a 15% capital gains/dividends rate, and an 8% after-expense return.

Variable Annuity – Grows at 8% per year, then at the end gains are taxed at 33%

Mutual Fund- Grows at 7.7% per year (assume 2% yield each year is taxed at 15% before being reinvested), then at the end gains are taxed at 15%.*

When does the after-tax return on the VA first exceed the after-tax return on the mutual fund?  After 86 years.  What?  You don’t expect to live another 86 years?  Exactly.

Tax-deferral is valuable, but not that valuable.  Doctors, as a general rule, are paranoid about taxes because they don’t understand them very well.  This causes them to dive into “tax shelters” that they never really needed anyway.


2) Lack of Flexibility in a Variable Annuity


If I own a mutual fund in a taxable account, I can sell it any day the market is open and buy another one or just take the proceeds, pay taxes on them, and purchase a boat.

It takes far more time to surrender an annuity contract, get your money, and move on.  If you want to exchange one VA for another, you get to go see another agent, sign another contract, move the money etc.  The Etrade baby can’t swap one for another with a couple of clicks of his mouse, like he could with a mutual fund.  You can call and make changes WITHIN a variable annuity, but there’s usually a limit as to how often you can do this without paying additional fees.


3) Poor Investment Choices in a Variable Annuity


Most VAs are chock-full of poor investment choices.  The “sub-accounts” (mutual-fund like investments within a variable annuity) are often poorly-performing, actively managed funds with little incentive to keep fees low.  Although you can get a variable annuity from Vanguard (in cooperation with an insurance company) or other mutual fund house with better choices, most of the VAs sold by annuity salesmen (insurance agents) are composed of inferior sub-accounts.


4) A Variable Annuity Has Surrender Fees


Annuities are supposed to be long-term investments.  With a fixed annuity, the insurance company takes your money and puts it into longer-term investments, like stocks and bonds, then pays you each month.  In order to allow it to do so, it needs to be able to hold on to your money for a long-term period, so to encourage you to leave the money there they instituted surrender fees.

When they started offering variable annuities, they carried the rather profitable practice over.  Surrender fees generally start at about 7%, generally decreasing by 1% a year.  Sounds like a load, no?  Would you buy a loaded mutual fund?  Of course not.  So why would you buy a loaded VA?  The company has to pay the salesman somehow don’t they?


5) Mortality and Expense Fees in a Variable Annuity

Since a variable annuity is an insurance product, it has to provide some kind of an insurance function.  Usually, this is a guarantee that even if you die your heirs will get the greater of the value of the account or the amount you invested in it.  This is a nearly worthless guarantee at a high price.

Let’s say you had a VA you’d put $100K into.  A typical M&E expense is 1.1%.  So if the value of the VA had decreased by 25% to $75K, and you died, your heirs would get $25K from “the policy” (plus the $75K from the annuity.)  It’s like a $25K life insurance policy.

You pay 1.1% ($1,100 a year, and you’re covered for $25K or so.)  You might ask yourself at this point….how much is a $25K policy worth?  Well, for a 60-year-old male, a five year term life insurance policy goes for $249 a year.  So you’re paying over four times as much as you should.

Plus, the chances of you actually needing the policy aren’t that good.  If the account is worth MORE than you paid into it (and it darn well should be after a few years, it’s an investment after all), it doesn’t pay anything.

It’s interesting to compare a Vanguard Variable Annuity to a similar Vanguard Mutual Fund.  Keep in mind that Vanguard runs these things essentially at cost, so this likely reflects the true cost of that policy.

The ER for the Vanguard Total Stock Market Mutual Fund is 0.18%**.  The total ER for the Vanguard Total Stock Market VA is 0.50%.  So Vanguard (and the associated insurance company) can do it for about 0.32%.  Why would anyone pay 1.1%, over 3 times as much?  Looks like insurance company profit to me.  I won’t even go into the other fees commonly detailed in the very fine print within the prospectus.


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6) No Step-up In Cost Basis Like You Get With a Mutual Fund


When you die with a mutual fund, your heirs get a step-up in basis.  That means, for tax purposes, that it’s as though they bought the mutual fund themselves on the day you died.  They can immediately sell it and owe no capital gains taxes.  When you die with a VA, all those earnings that have been deferred for years are fully taxable to your heirs, and not at the favorable capital gains rates either.  I can tell you which one I’d prefer to inherit.


Savannah Headstones
their heirs got a step up in cost basis


7) Rebalancing Isn’t A Big Issue For Mutual Funds


Proponents of VAs frequently cite the fact that you can rebalance your portfolio without any tax consequences if you’re invested in a VA.  While that is true, the tax consequences of rebalancing can be minimized or even eliminated pretty easily.

First, you can do all your rebalancing within your IRAs, 401Ks or other tax-protected accounts.  Second, within a taxable account, you can use distributions of dividends and capital gains to rebalance.  Third, you can always use new contributions to rebalance.

In fact, studies show that it’s best to only rebalance every 1-3 years.  So far, after 8 years of investing, I’ve never paid taxes in order to rebalance.  I don’t anticipate EVER having to.  That might not be the same for everyone, but it is pretty easy to minimize the tax hit for most.

Also, keep in mind that it takes pretty serious market fluctuation to actually generate a need to rebalance.  Consider that you have a 50/50 stock/bond portfolio and wish to rebalance it if it gets off more than 5%.  How much more does the stock portfolio have to outperform the bond portfolio in a year for you to need to rebalance?  By about 25%.  What percentage of the time are your stock and bond returns more than an absolute 25% different?  Not very often.


8) You Shouldn’t Be Market Timing Anyway

Proponents also argue that being able to swap funds around within the VA without tax consequences is a huge advantage for an aggressive investor.  While ignoring the fact that most mutual fund investors have enough assets within tax-protected accounts to do plenty of tax-free market timing, the truth is that the less jumping around between investments, chasing performance and timing the market you do, the better your returns are likely to be.  Buying and holding a static asset allocation takes the emotions out of investing, and produces better returns over time.  You’re not Warren Buffett.  Get over it.


In short, variable annuities are for the most part an investment made to be sold, not bought.  There may be a role for one in a few, very limited circumstances, primarily for those who mistakenly bought an expensive one and wish to transfer into a less expensive one or for those with little tax-protected space who wish to invest in very tax-inefficient assets such as TIPS or REITs.  You will likely be better off not mixing insurance with investing.  Don’t be so afraid of taxes that you let the tax tail wag the investment dog.  There are far worse ways to invest than in tax-efficient asset classes within a taxable account.


[PoF: *My tax drag is about 0.58% as opposed to 0.3%. In addition to the 15% capital gains tax, I also pay a state income tax of 9.85% and the ACA surtax of 3.8%. Assuming a 2% dividend, I’m paying nearly 29% of the dividend in taxes. It will drop when my income drops.

** Since this post was originally published, the Admiral fund (minimum $10,000 investment) version of Vanguard’s Total Stock Market Fund has dropped to 0.04%.



Readers, have you purchased a variable annuity or other “product that is best described as a mutual fund wrapped in an insurance wrapper and covered with fees”? Any qualms with the assertions?

Commissioned salespeople need not respond. As Upton Sinclair famously said, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

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10 thoughts on “8 Reasons Why You Should Invest With Mutual Funds Instead Of A Variable Annuity”

  1. Pingback: 10 Lessons Learned Along This FIRE Journey - DrDons 'Selected News You Can Use' Media
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. In general in would say that insurance products do a great job of protection but a poor job of investment.
    The benefits of pooling really help if you want protection against your house burning down or you want a vanilla life annuity to protect against outliving your finances. But when insurers mix these with investment options then the benefits decline and the costs increase.

  4. The conclusion I came to is that four conditions have to be met for a Variable Annuity to be worth doing:

    1) You’ve already maxed out all other retirement contributions, because Roth and non-Roth IRAs and HSAs and 401ks are all vastly superior.

    2) You are investing in high-yield bonds or maybe REIT. Why? Because if you are investing in bonds, the interest rate is too low for deferral to mater. If you are investing any thing where there is a lot of capital gains (stock), then you shouldn’t be in an annuity as capital gains tax rates are so far superior. Only high yield bonds make the cut for me.

    3) You get the cheapest variable annuity there is. Vanguard is the cheapest I could find. The all in cost for the high yield bond is .57%.

    4) You will probably use up the annuity before you die. Because the step up in basis is huge, and if you die an leave an annuity, you failed in estate planning.

    So, based on that, I thought I was getting a good deal investing in the Vanguard high-yield (which I really wanted to own for a portion of the portfolio). But then White Coat Investor wrote an article saying under any circumstance, I think, the variable annuity fails.

    Since the only cost of getting the deferral is the difference between the Variable Annuity expense of .57 and the cost for the same fund in a taxable brokerage account (.13% in Admiral shares), then I’m paying .44% for the deferral. The SEC yield is 4.66%.

    I’m just not good enough at spreadsheets to really see how long the breakeven, if ever, would be on that, or if it’s truly always negative in any expense.

    • I don’t recall ever saying a VA always fails, but you’re right that you need to do the math to see if the insurance cost will outweigh the tax cost for you.

      If you’re really going to have a big VA, you probably want Jefferson National’s fixed annual fees rather than Vanguard’s expense ratios. The opposite is true for a small VA.

  5. I am probably thoroughly confused about the matter, but I’m pretty sure our work sponsored retirement is annuities through Valic. Is there anything we can do about that?

    • Possibly.

      The first thing you can do is learn all about the plan, the fees, and your options. If it’s truly your only option and a bad one, you might want to contribute only enough to get the employer match (if one exists) and if not, perhaps not at all. Here are a couple Bogleheads threads on Valic annuities within retirement plans: Link1 Link2

      You can also try lobbying your employer for a better plan. Maybe get some other people on board to complain, as well.

      Good luck!

  6. Fantastic summary of why annuities are not generally a good option. I have several people that have asked me about variable annuities and now have a great, thorough article that I can refer them to. I usually just mention high fees and higher taxes, but there are SO many other reasons listed here that are just as valuable.

  7. When I started learning about investment I received a really good (in my opinion) advice. A colleague of mine told me this, “You wouldn’t buy your groceries from a car mechanic or ask your dentist to check your prostate*, wouldn’t you?” My answer was no. He continued, “That’s the reason why you don’t want to buy your insurance from someone who’s not in the business, and you don’t buy investments from insurance world”

    * He actually used this example, I am not kidding.

  8. Unfortunately I was sold on a permanent life policy my senior year of college. I contributed a fairly significant amount of money each month to cover my policy. The quick numbers are: I contributed a little over $19k and my investment amount, or more properly defined as my cash value, was worth $12k. Not good…

    Luckily, I was introduced to the personal finance/FIRE community and I cashed out my policy and put the cash into my taxable account. Now I have term life coverage until my investments reach a point where I no longer need term life coverage.


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