| For starters, you really shouldn't be plunking your hard-earned money into broker-sold investment products. These are ideal for only one kind of person: the guy or gal who sells them. Variable annuities offer the highest sales commissions in the industry and - believe it or not - the SEC doesn't even require them to be disclosed in the prospectus. Back when I was at Merrill Lynch, an annuity salesman dropped by our morning meeting one day and hit us with this pitch... "If your client puts $1 million into this annuity, we will pay you a $100,000 commission that day. Yet the annuity will still show up in his account as having a $1 million value. What's more, your client can take the prospectus to a forensic accountant and he will never discover that you earned 10% on this sale. It's not disclosed anywhere in the paperwork." Armed with this vital information, the brokers stampeded out of the meeting, got on the horn and began pitching this incredible product. While brokers generally do a bang-up job of summing up the positives of variable annuities (and each one is different), they either ignore or don't fully understand all the negatives. Let's consider them here: - Annuities are not FDIC-insured.
- Withdrawals prior to age 59 1/2 are generally subject to a 10% IRS penalty.
- These are the most fee-laden investment products in the financial industry. Average annual expenses are up to three times higher than a typical mutual fund and up to 30 times higher than a typical Vanguard index fund. This, of course, sharply reduces your future investment returns.
- If you cash in a variable annuity, the IRS will tax your gains (if you have any) at your income tax rate rather than at the lower capital gains tax rate. Your actual tax burden may be fairly low since the high annual fees will dramatically lower your long-term investment returns.
- You can get most of the same tax-deferral benefits (at one-thirtieth of the cost) by simply buying and holding a Vanguard equity index fund or municipal bond fund. Or you can buy and hold individual stocks. (So much for the big "tax advantage.")
- If inflation stays high, your fixed annuity payments will lose their purchasing power. (Insurance agents will counter that some products allow policyholders to raise their annual payouts by 1% to 3% a year. But that requires you to start with lower payments. There's no free lunch.)
- Oh... and about that principal guarantee. Your contract - contained in a prospectus up to 2 inches thick - will require you to hold the annuity for many years to realize that guarantee. If you cash it in sooner for some reason, you will be hit with an additional fee - called a surrender penalty - equal to up to 10% of your investment.
- Even if you hang in there for years or decades, a guarantee is only as good as the issuer. Understand that you are surrendering your principal to the insurance company immediately. And while your agent may boast about his company's high rating from AM Best, it's worth remembering that the world's biggest insurance company, American International Group, imploded in the 2008 financial crisis and had to be bailed out by Uncle Sam.
How confident are you that your insurance company will be bailed out in the future? Yes, there are state industry-backed guaranty associations, but they have limits. In a major crisis, they may not cover your insurer's insolvency. (To find your state's limit, go here.) So, yes, variable annuities offer certain advantages. But, in virtually every case, they are swamped by all the drawbacks. However, an immediate annuity is a different animal altogether. For certain investors, they make perfect sense. I'll explain the pros and cons of these investments - and the best place to get them - in my next column. Good investing, Alex | 
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