Variable Annuity Non-Guarantees: Eroding or Enhancing Long-Term Returns?

Variable annuities offer the potential for market-linked growth, but their long-term performance is significantly shaped by non-guaranteed elements. These elements, primarily investment subaccount performance, fees, and optional riders, introduce variability and risk that directly impact the ultimate returns an investor can expect. Understanding how these non-guarantees function is crucial for sophisticated investors considering variable annuities.

The most prominent non-guaranteed element is the performance of the chosen investment subaccounts. Unlike fixed annuities, where returns are predetermined, variable annuity values fluctuate based on the underlying investments, which are typically mutual fund-like portfolios. This market exposure is a double-edged sword. In bull markets, subaccount growth can substantially enhance returns, potentially outperforming guaranteed fixed rates. Imagine a scenario where the S&P 500, a common benchmark for subaccounts, experiences average annual returns of 8% over a 20-year period. A variable annuity linked to such subaccounts could generate significant growth, far exceeding what a fixed annuity with a 3% guaranteed rate might offer. However, the non-guaranteed nature means that during market downturns, especially prolonged bear markets, subaccount values can plummet, directly diminishing the annuity’s value and eroding potential long-term returns. Sequencing risk, the danger of market losses occurring near retirement when withdrawals begin, is amplified in variable annuities due to this non-guaranteed investment performance.

Fees represent another critical non-guaranteed element that persistently impacts long-term returns. Variable annuities are known for their layered fee structure. Beyond the standard expense ratios within the subaccounts themselves, which are non-guaranteed and subject to change by the fund manager, annuities levy additional fees. Mortality and Expense (M&E) risk charges, administration fees, and contract maintenance fees are common. These fees are deducted annually from the annuity’s value and, while often presented as a percentage, their cumulative effect over decades can be substantial. Consider a variable annuity with a seemingly modest 1.5% annual M&E charge. Over 20 years, this fee alone, compounded annually, can reduce the overall return significantly, even before considering subaccount expense ratios and market fluctuations. These fees are non-guaranteed in the sense that while the M&E charge might be contractually fixed, the underlying expenses of the subaccounts and other administrative costs can vary and potentially increase over time, further impacting net returns. This fee drag is particularly detrimental in periods of lower market returns, as it eats into any gains and exacerbates losses.

Optional riders, such as guaranteed minimum income benefits (GMIBs) or guaranteed minimum withdrawal benefits (GMWBs), also introduce non-guaranteed elements, albeit in a different way. While these riders offer guarantees, their costs are not fixed and can be adjusted by the insurance company under certain contract provisions. Furthermore, the benefits themselves are contingent on the insurer’s financial stability, which, while generally robust, is not entirely without risk. The cost of these riders, typically expressed as an annual percentage fee, further reduces the overall return potential of the annuity. While they provide valuable downside protection or income guarantees, investors need to understand that these guarantees come at a price that impacts long-term growth. The decision to include riders involves a trade-off: reduced potential upside in exchange for downside protection or income security. The “non-guaranteed” aspect here lies in the potential for future fee adjustments and the inherent, albeit small, credit risk associated with any insurance product.

In conclusion, non-guaranteed elements are integral to the nature of variable annuities and profoundly influence long-term returns. While subaccount performance offers the potential for enhanced growth, it also introduces market risk. Fees consistently erode returns, and optional riders, while providing guarantees, further reduce potential upside. Advanced investors must carefully weigh these non-guaranteed elements, understanding their potential impact on both positive and negative return scenarios over the long term, and consider whether the trade-offs align with their individual risk tolerance and financial goals. A thorough analysis of subaccount options, fee structures, and rider costs is essential for making informed decisions about variable annuities and their role in a long-term investment portfolio.