Written By
Carlos M. Sera, MBA
Published On
September 13, 2017
Before making an investment decision people need to ask themselves, “Is there a better alternative? Is there something better to invest in than what I am considering?” If you routinely ask these questions, not only will it help you develop your investment acumen, you will be able to eliminate entire types of investment alternatives.


This tale will give you some framework to see how you can analyze different types of investments.  In particular, this tale focuses on analyzing annuities, specifically fixed vs variable annuities, as well as alternative investments.  However, we call it An Alternative Tale because you must always look to compare one investment to another and then choose the alternative that best fits your situation.

We should note that we are neither proponents of annuities nor detractors. On one hand, we have seen many situations where an annuity solves the situation at hand exactly, and the investor couldn’t possibly be happier.  On the other hand, we have also seen certain types of annuities that absolutely stink, and we wonder how anyone could allow one of their clients to own something so costly and complicated.

Let me touch on a subject that appears to cause a lot of confusion.  There are some people out there – mainly insurance agents and sales-driven advisors, which I call SADS because you will be sad if you listen to them – that think people should own annuities in retirement plans.  We are not of this ilk though we have seen one situation for an ultra high net worth family where it made sense.

However, one situation in 35 years of looking at individual portfolios is an exception to the rule and not the rule.  In general, tax-deferred investments such as annuities in a tax-deferred account are self-serving at best.  Why do we see them where they don’t belong?  The answer is two-fold.  The first is that with the exception of registered investment advisor directed annuities, annuities pay the selling agent a sizeable commission.  The second is because the buyer wants peace of mind and is willing to sacrifice rate of return for it.


Let’s get started.  All annuities are tax-deferred investments sponsored by insurance companies and come in two varieties.  The first is the fixed variety and pays a fixed rate.  The second is the variable variety and pays a variable rate.  What they typically have in common is a high commission to the person (or SAD) that sells these to you.

If you happen to run into one of these people, I suggest you run – do not walk – to the nearest alternative advisor.  Any advisor that would make a recommendation to own a tax-deferred investment in a tax-deferred account is no friend of yours, with the one exception for ultra high net worth families.  They are acting in their own interest and if you are gullible or uninformed enough to take their advice, shame on you.  Don’t own a fixed or variable annuity in a tax-deferred account, there are better alternatives.

The next logical question is should someone own annuities at all?  Should you own them in a taxable portfolio?  Our general rule is no, but it isn’t a hard and fast rule.  We can see how someone, after contributing the maximum allowed to their retirement plan, would want to invest in a tax-deferred vehicle.  What we caution is they must make sure they read the fine print of whatever they buy because some of these annuities are very expensive and will “fee” your portfolio until they make more than you do.


Typically we avoid annuities, but we can understand why someone might like them.  Why do we say to avoid annuities?  Since this tale is about alternatives let’s look at some alternative investments to annuities.  We’ll examine the two most common situations or comparisons that an investor should analyze in a taxable situation.  We will see that in both cases the alternative investment is superior to the annuity.  In the first situation, you have to make a choice between investing in a tax-deferred fixed annuity or a tax-free investment such as a municipal bond.  In the second situation, you have to make a choice between investing in a tax-deferred variable annuity or an index fund.  Which is the best choice?

Let’s take these two one at a time. The analysis between the fixed annuity and the tax-free investment is simple to make. You simply calculate the after tax rate of return and choose the one that gives you the most money.  There are calculators available to do this or you can contact your accountant if you can’t understand the math.  Fortunately, if you make the wrong decision in this case, the consequences are not punitive.  I don’t want to be overly harsh on fixed annuities in taxable accounts.  I can see why people invest in these, even if they are inferior investments.  People aren’t perfect and if they make this type of error, it isn’t the end of the world.  However, if you choose to invest in a variable annuity instead of a comparable index fund then you are possibly committing a grave financial error.  Let me tell you why.

Every variable annuity we’ve analyzed, with the exception of a few, are actually wearing a disguise.  They disguise themselves as tax-deferred stock mutual funds but they have a problem they won’t reveal.  They keep their mask on and never let you know what you are missing.  What are you missing other than exorbitant fees?  Variable annuities don’t let you take advantage of the low taxes on dividends and long-term capital gains that come with owning an equivalent mutual fund.  They may grow tax-deferred, but when you want to convert your money to income one day, your income is subject in most cases to higher tax rates than dividends and long-term capital gains.  It’s a little secret.


This tale teaches us to look at alternatives and alternatives require an understanding of how things actually work.  The rest of this tale will focus on comparing the merits of investing in a variable annuity vs. investing in a low cost stock index fund like the S&P 500.  Let’s do the type of analysis that sheds the most favorable light possible on variable annuities, what you will be pitched when someone wants to sell you a variable annuity, and then progress from there to reality. Let’s compare the best-case typical variable annuity to a similar investment in a stock index fund.

Let’s make some assumptions. Let’s assume that the S&P 500 index fund goes up 9.60 percent per year for 30 years and that you invest $10,000 at the beginning of the 30 years in both alternatives.  You have to pay taxes along the way at the rate of 30 percent on dividends and long-term capital gains from you index fund but only 33% of the 9.60% is taxable.  The reason you use 33 percent is because historically about one third of the returns from a the S&P 500 come from dividends and long-term capital gains while the other 67 percent comes from tax-deferred capital appreciation.  You see, the variable annuity purveyor will never explain that a stock index fund is an extremely tax efficient way to grow your capital.  In the tax-deferred variable annuity, we assume it also grows at 9.60 percent per year for 30 years.  We use 9.60 percent because it is a good estimate of an expected return over 30 years.  It could be more or less but it doesn’t matter for the purposes of evaluating which investment is better.

How much money do you have in the variable annuity compared to the stock index fund?  You will have $156,429 in the variable annuity compared to $120,460 in the stock index fund.  Right now, it seems like the variable annuity is winning.  But what really matters is the conversion of capital in the variable annuity as well as in the index fund to an income stream.  Said differently, how much can I spend from what I’ve saved.  Things start to equal out right about now.  If we keep the same 9.60 percent rate of return, the variable annuity lets us spend $10,512 per year and the stock index fund lets us spend $10,523 per year.  This is virtually the same, and I would be indifferent between the two.  In fact, I might have put $5,000 in the variable annuity and $5,000 in the stock index fund if I expected things to work out this way.


What we have modeled above is the best-case scenario in our opinion.  The reality is that variable annuities carry significant fees and fees are the primary differentiator between those that are good and those that stink.  We have seen variable annuities in our travels with hidden fees as high as 3.5 percent annually which makes them a terrible investment when compared to a stock index fund.  To see how even a 2 percent differential hurts your income in retirement, let’s drop the return on the variable annuity to 7.60 percent.  What happens to our money in this case?  After 30 years, we only have $90,026 in the variable annuity instead of the unrealistic case of $156,429 and our income drops from $10,512 per year to $4,789. Even a 2 percent differential is generous.  Most variable annuities are high cost, higher than 2 percent and we don’t recommend them.

Let’s complete the final whammy on variable annuities.  Can you guess what it is?  If you answered, “The income from variable annuities is taxed as ordinary income,” then they look even worse.  As of this writing, the tax rate is 39 percent, which drops the income you will be able to spend from $4,789 to $4,174.  We think this is adding insult to injury.  Give us a stock index fund any day.

Some people look at the above and say, “My variable annuity will outperform the S&P 500.  I don’t believe this is fair comparison because mine is better.”  Do the words Brooklyn and Bridge mean anything to you?  When the majority of mutual funds – almost 80 percent – underperform the S&P 500 index, don’t let yourself think that your variable annuity is the needle in the haystack.  It isn’t.

As I said at the beginning of this tale, there are many inferior investments.  The vast majority of annuities are just one kind.  The list is long but you can analyze every investment by comparing it to the basic building blocks of stocks, bonds and cash.

Carlos M. Sera, MBA

Carlos M. Sera, MBA

Founder, Sera Capital
Carlos Sera is a wealth advisor professional, speaker on financial and investment planning, author of Financial Tales, registered investment advisor representative, and first-generation Cuban-American with Spanish fluency. Carlos has an MBA from the University of Rochester in Finance and Applied Economics, and a BA degree from Johns Hopkins University in Natural Science.

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