ariable annuities are complicated investment products that have created much confusion and controversy in the investment world. It is our opinion that variable annuities can be oversold by financial professionals and at times they may not make sense for an investor. Investors must understand the fees they are paying, what benefits they may receive for those fees, and the risks they are assuming in connection with the investment.
At the same time, one should also understand that a variable annuity can be a valuable tool for certain investors and can help an investor achieve additional diversification in their portfolio. A variable annuity may provide some protection of your investment assets during down market years, while potentially allowing your investments to grow in good market years. They may provide an income stream at retirement and they may offer attractive death benefits for an investor’s heirs. It is important that those investing in a variable annuity do so at the right age and understand the role that the annuity plays in their overall financial plan. The following guidelines will help you understand some of the key benefits, drawbacks and features of variable annuities.
What is a Variable Annuity?
A variable annuity is a contract between you and an insurance company, under which an investor purchases the contract by making either a single purchase or a series of purchase payments over time. The insurance company then agrees to make periodic income payments to you, beginning either immediately or at some future date.
A variable annuity offers a range of investment options. As with most investments, the value of your investment within a variable annuity will fluctuate depending on the performance of the investment options you choose. The investment portfolios for a variable annuity typically invest in stocks, bonds, money market instruments, or some combination of the three.
How Variable Annuities Work
A variable annuity contract is typically structured in two phases: an accumulation phase and a payout phase.
- Accumulation Phase: During the accumulation phase, you make purchase payments either with a lump sum contribution or a series of contributions over time. These contributions are then allocated to a series of investment options such as sub-accounts. The money you have allocated to each mutual fund investment will increase or decrease depending on the fund’s performance. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account. A fixed account pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum. During this accumulation phase, an annuity holder can typically transfer money from one investment option to another without having to pay tax on the income and gains. However, some insurance companies may charge a fee for these transfers. Please note that transferring money from investment options is different form withdrawing money from the contract. Those who withdraw money from an annuity contract, in the accumulation phase, may be subject to surrender charges, penalties and taxes.It is important for investors to request and review the prospectus for each of their investment options within the variable annuity. While reviewing the prospectus, pay close attention to the fund’s objectives, fees and expenses as well as the risks associated with the sub-accounts.
- Payout Phase: During the payout phase, an annuity holder may receive their contributions plus investment income and gains (if any) as a lump-sum payment, or they may choose to receive them as a stream of income payments at regular intervals (generally monthly). Some annuities are structured as an immediate annuity, which means that there is no accumulation phase and income payments will start immediately after purchase. Many annuities offer living benefit riders such as Guaranteed Minimum Income Benefits (GMIB) or Guaranteed Minimum Withdrawal Benefits (GMWB), all of which are subject to additional fees. For those wishing to defer their income from the annuity to a later date, the insurance company agrees to increase the income base of the contract at a certain percentage of the purchase payment(s) (for example 5% per year) during the accumulation phase, exclusive of the actual performance of the investments. Once the annuity holder is ready to receive income from the annuity, the insurance company will pay the contract holder a guaranteed income stream based upon the income base. These benefits were designed for the investor who is worried about the fluctuations of their investments and their retirement income ceasing. Although they want their investment value to grow over time, they also want to have a more predictable income base should those investments underperform.
Some Potential Benefits of Variable Annuities
- Variable annuities may let you receive periodic payments for the rest of your life (or the life of your spouse or any other person you designate). This feature offers protection against the possibility that, after you retire, you will outlive your assets.
- Some variable annuities offer a death benefit. If you die before the insurance company has started making payments to you, your beneficiary is guaranteed to receive a specified amount—typically at least the amount of your purchase payments. This helps your beneficiaries if, at the time of your death, your account value is less than what you contributed to the annuity.
- Variable annuities are tax-deferred, which means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long term goals.
- Variable annuities offer investment portfolios which may allow investors to remain growth oriented if they so choose. At the same time, the annuity provides some living benefits which allow the purchase payments into the annuity to increase as an income base, regardless of how the investments perform. This feature may be attractive if, at the time income is needed, the market and the investments within the annuity have performed poorly and are worth less than the purchase payments made into the annuity.
Some Potential Risks and Drawbacks to Variable Annuities
- Although variable annuities may provide benefits such as income benefits, death benefits, or bonus credits, purchasers of variable annuities should understand that those benefits come with additional fees. Annuities have fees, including, but not limited to, administrative expenses, mortality and expense risk charges, fees for the investments within the annuity and advisor fees. Annuity owners should carefully weigh the benefits provided by the annuity as well as all expenses associated with those benefits, in order to determine if those benefits are worth the expense.
- Annuities are considered “illiquid” investments. Those seeking to liquidate proceeds from an annuity, especially in the early years, could be subject to surrender charges and penalties. Potential annuity owners should carefully review the surrender periods associated with a particular annuity. They should also review the charges and penalties associated with liquidating money from the annuity during those surrender periods. Investors should avoid putting money into a variable annuity if that money is intended to be “liquid” and accessible.
- The benefits and riders provided by the insurance company are only as good or reliable as the insurance company providing those benefits and riders. Variable annuity guarantees are all subject to the claims-paying ability of the insurance company issuing the annuity. It is therefore important to consider companies with strong balance sheets and strong ratings.
- Those who purchase variable annuities should understand the risk that their account value may decrease if the underlying investment options perform badly.
- Those investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or an IRA) will get no additional tax advantage from the variable annuity. Under these circumstances, consider buying a variable annuity only if it makes sense because of the annuity’s other features, such as lifetime income payments and death protection. The tax rules that apply to variable annuities can be complicated. Before investing, you may want to consult a tax adviser about the tax consequences to you of investing in a variable annuity.
Do your homework before investing in any annuity. The content on this page is designed to give you a very basic understanding of variable annuities and it should not be relied upon solely in making decisions regarding investments in a variable annuity. There are many insurance companies that offer these products. Each of the products can differ in benefits, fees and risks. It is important to find a financial professional who is independent and not required to sell any particular annuity product. Be sure your financial advisor does his or her homework in researching multiple annuity products and that they educate you about the various benefits, risks and drawbacks associated with those products. A qualified financial professional cannot mitigate the risks associated with annuities, but they can help educate you on the options available.
You may also download and review “Variable Annuities, What You Should Know”, which is a manual put together by the US Securities and Exchange Commission to assist investors in learning more about variable annuities. You can download this guide by visiting the link below.