Let me start with a confession: I hate variable annuities.

Source: ©iStock.com/hannahgleg

Well … hate is a strong word, so let me rephrase: I despise them with an unholy passion.

To be fair, not all annuity reps are snake oil salesmen, and there can be specific situations where an annuity might make sense for a given investor. But by and large, annuities as retirement products are a lousy deal for investors.

Let me explain.

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The Sales Loads Are Outrageous

It’s often joked that hedge funds, with their 2% management fees and 20% performance-based fees, are less an investment vehicle and more a compensation scheme for the manager. Well, you can make the same criticism of annuities. While sales loads have mostly disappeared on most stock and mutual fund orders as the industry has moved to an RIA fee-based model, they are alive and well in the world of annuities.

In addition to the management fees you generally pay on the underlying investment funds and the assorted administrative and insurance costs, you also usually pay a sales load that can be 7% or higher.

If you’re “lucky,” the load will come in the form of a surrender charge that eventually falls to zero. But this generally means that you’re trapped in the product for 7-10 years. There are some annuity issuers out there, such as pioneer Jefferson National, that have no sales charges and have very reasonable internal expenses. But these tend to be the exception and not the rule.

The Tax Benefits Are Overrated

If you are still in the accumulation phase (i.e. still contributing new savings), then variable annuities offer a modest amount of tax relief. Your dividends, interests and any realized capital gains are tax free until you begin taking distributions after age 59 1/2.

But here’s where it gets sticky. Annuity withdrawals are taxed on a last in, first out (“LIFO”) basis. It’s probably easiest to explain this by using an example.

Let’s say you invest an initial $100,000 and it grows to $150,000 by the time you decide to retire. If you take a lump-sum distribution, you pay regular income tax on the first $50,000 you take out. No taxes would be due on the remaining $100,000, as this is simply a return of principle. If you annuitize and take monthly payments, a formula is applied in which a portion of the payment is considered taxable income and a portion is considered a non-taxable return of capital.

That sounds good, right?

Well, if that is where the story stopped, I’d say that the tax benefits were great. Unfortunately, there is more.

When you die and pass your assets on to your heirs, there is generally a step-up in basis. Your heirs get to start fresh with a cost basis at current market levels.

Not so with annuity products. Your non-spouse heirs will have to pay taxes on all of those accumulated earnings.

Inability to Give an Inheritance or Fund a Charity

If you decide to annuitize, or convert your nest egg into a lifetime guaranteed income stream, you have a degree of retirement security. You know what your payout is going to be, and it doesn’t depend on stock market returns or changes in bond yields.

Again, this sounds good. But there are a couple points to consider. First off, the payouts aren’t all that great these days. A lifetime guaranteed payout for a 60-year-old man offers an annual cash flow between 4% and 6% at current rates.

Sure, that’s better than what you’ll find in an investment-grade bond ladder or in a portfolio of blue-chip dividend-paying stocks. But once you die, the principle belongs to the insurance company. You have no ability to leave an inheritance to your heirs or a bequest to your church or favorite charity.

Personally, I’d prefer to take my chances with a portfolio of dividend paying stocks. The immediate payout is smaller, but dividends generally grow over time, and the principle remains mine to do with as I please. If, in my senile old age, I decide to leave my entire fortune to a Brazilian go-go dancer in Copacabana, I would have the freedom to do so.

Any Reason for Annuities?

So, is there any scenario in which an annuity makes sense?

Maybe. Let’s say that you earn a high current income and that you’ve already maxed out your company’s 401k plan ($18,000 in 2015, or $24,000 for investors 50 and older). And let’s say that you’ve also already maxed out your IRA or Roth IRA contributions, if you qualify, and any other deferred comp plans your company might offer.

If you still have excess savings that you’d like to shield from high current taxes, a variable annuity is not the worst option, and it has the added benefit of having a layer of protection from lawsuits or creditors in most states.

But for most investors, it makes sense to simply invest their excess savings in tax-efficient mutual funds, ETFs or a basket of quality buy-and-hold stocks. Save yourself the fees and unnecessary complexity that comes with an investment in annuities.