Figuring out which financial products to invest in for your retirement strategy is no easy feat. From 401(k)s to IRAs to CDs and bonds to annuities, the options are both endless and confusing. Within the annuity world, there are a variety of annuity contract types and additional riders. Each choice you make can greatly impact your retirement income.
Variable annuities are one of three major types of annuities. The other two are fixed annuities and fixed-index annuities. Keep reading to understand how these types differ, the benefits and drawbacks of variable annuities, and how they align with different investment objectives.
What Are Variable Annuities?
Like fixed annuities, a variable annuity is a contract between an individual and an insurance company. However, variable annuities are both insurance and security products. They are sold by security salespeople and regulated by both FINRA and the SEC.
Variable annuities allow the annuity owner considerable flexibility to allocate their annuity premiums in a variety of investments via sub-accounts. They may also offer benefits such as income riders and death benefits at an additional cost. However, there is no principal protection in this type of annuity. The risks involved are the same as investments in stocks, bonds, or mutual funds.
You can learn more about variable annuities on this informational page from the SEC.
How Variable Annuities Work
On the surface, variable annuities work similarly to other annuity insurance products. When you purchase a variable annuity, you provide a lump sum or series of premium payments to an insurance company. In return, the insurer agrees to pay you a regular income stream, either right away or at a set time in the future.
Here is where variable annuities differ from fixed annuities. Fixed annuities grow at a set interest rate until they annuitize, but variable annuities have various sub-accounts that are invested in securities, making the interest differ over time. The investment accounts offered in a variable annuity are typically managed by someone other than the insurance company and there are often fees charged by those fund managers.
These sub-accounts enable variable annuities to offer a higher potential return but also mean that your annuity is subject to market risk. The value of your annuity can change based on the performance of the investments within the sub-accounts.
The lifecycle of a variable annuity is split into two phases: accumulation and distribution. During the accumulation phase, you make premium payments, which are allocated to your chosen sub-accounts. Your account then grows tax-deferred based on the performance of your sub-accounts.
You can begin the distribution phase once the annuity reaches maturity. During the distribution phase, you can turn the accumulated value of your variable annuity into income–a process called annuitization. You have other options at maturity, such as withdrawing the funds in a lump sum, transferring the funds to another annuity, or renewing your current annuity for another term.
It’s important to note that variable annuities are designed for long-term savings and offer limited liquidity prior to maturity. If you make withdrawals during the surrender period before payouts begin, you may have to pay surrender charges.
Variable Annuities vs. Other Financial Products
When deciding how to secure your retirement, it’s important to understand the differences offered by each type of investment. Here is a quick overview of how variable annuities compare to other financial and insurance products.
- Bank CDs: CDs are similar to variable annuities in their lack of liquidity, but variable annuities provide higher potential returns than bank CDs and the ability to annuitize payouts. Variable annuities also offer tax-deferred growth.
- 401(k)s and IRAs: Like 401(k)s and traditional IRAs, some variable annuities (also known as qualified variable annuities) are funded with pre-tax dollars. While 401(k)s and IRAs can give you some income for life in some scenarios, Annuities are designed to help ensure you do not run out of money in your retirement.
- Stocks and Mutual Funds: While annuity sub-accounts are subject to market risk, this financial product features benefits like tax deferral, lifetime income riders, and death benefit riders to enhance their value.
- Fixed Annuities: Where variable annuities enable you to enjoy capital gains from stock market performance, fixed annuities are not associated with the market at all and are therefore not subject to market risk. Instead, the account value in a fixed annuity grows at a pre-determined (often much lower) interest rate.
- Fixed-Index Annuities: While variable annuities grow or shrink in value based on the performance of certain assets, fixed-index annuities grow because insurance companies credit interest at rates that are linked to the performance of a specific market index, like the S&P 500. The difference is that variable annuity premiums are divided into sub-accounts that rise and fall in value. Fixed-indexed annuities, on the other hand, only use market indices as a benchmark, as it is impossible to invest directly in an index. Indexed annuities also offer principal protection and a guaranteed minimum interest rate as well as a cap on growth.
Pros and Cons of Variable Annuities
A variable annuity is a complex financial product and isn’t right for everyone. It’s important to understand the advantages and drawbacks of variable annuities before purchasing an annuity contract.
Variable Annuity Benefits
- Tax advantages: Variable annuities can be funded within a qualified plan, which means using pre-tax dollars and reducing your tax liability. In addition, all annuities grow on a tax-deferred basis, meaning you don’t pay taxes on your annuity’s growth until you withdraw funds.
- Investment flexibility: With sub-accounts, you get to decide where you want to invest your retirement funds. You can also usually switch money between sub-accounts without needing to pay capital gains taxes or fees.
- High reward: Because variable annuities are distributed directly into sub-accounts, they offer a higher potential growth rate than fixed and fixed-index annuities.
- Additional Benefits: Available for an additional cost, annuity riders can offer living benefits like guaranteed minimum income benefits, long-term care riders, and more.
Disadvantages of Variable Annuities
- Market volatility: Variable annuity sub-accounts can be subject to the stock market’s volatility and whims.
- No guarantee of principal: Variable annuities typically do not have protections for your principal investment. This means that if you need to withdraw your money, the value of your annuity may be lower than your original deposit. For an additional cost, some contracts may offer riders that guarantee a certain amount of your initial premium be paid as a death benefit to your beneficiaries.
- High fees: Variable annuities come with more fees than other annuity products, including management fees, rider fees, broker compensation fees, etc. These can significantly lower your return.
- Confusing contracts: Variable annuity contracts are highly complex and it is important to fully understand how they work, the features they offer and the fees required.
- State guarantee protection exemption: Variable annuities are exempt from the State Guarantee Protection Act because the invested assets are not at the insurance company; they are with the investment accounts.
- Potential tax liabilities for beneficiaries: Variable annuity contracts may provide a lump-sum death benefit to your named beneficiaries upon your death. However, they will owe any unpaid income taxes on the accumulated value of the annuity.
Variable Annuity Fees
One of the main issues with variable annuities is their high fees and associated penalties. Some examples of variable annuity fees include:
- Early withdrawal fees: Also known as surrender charges, these fees apply if you decide to withdraw funds or transfer your investment to another company before its maturity date. Withdrawals made before age 59 ½ are also subject to a 10% tax penalty by the IRS.
- Annuity rider fees: Fees for riders such as extended death benefits and guaranteed income can vary wildly, but average between .75% to 2% of the total annuity value.
- Loads and acquisition expenses: Some variable annuities have a front-end or a back-end load that can affect the overall performance of your annuity.
- Administration fees and distribution costs: Many variable annuities charge a fee for administrative expenses. These fees can range from .15% to .40% of your total account value.
Any gains from your annuity are taxed upon withdrawal at ordinary income tax rates instead of lower long-term capital gains tax rates. Likewise, if premiums were made with pre-tax dollars, withdrawals of these funds are also taxable.
How to Buy a Variable Annuity
The purchasing process for variable annuities is similar to that of fixed annuities, with a few notable differences. Follow the steps below to ensure you are making a smart choice for your annuity contract.
- Research annuity contract providers and evaluate their offerings. It’s important to choose a financially stable company with high ratings from agencies like AM Best. However, you should remember that past performance does not promise future results.
- Get quotes from multiple insurance companies. You’ll need to fill out a contact form and answer a few basic questions before receiving your quote.
- Review the annuity’s prospectus. A prospectus will disclose all aspects of information about the annuity such as features, goals of the annuity, investment options, legal notices, fees, and expenses.
- Ask about rider options, like lifetime income benefits, long-term care riders, and guaranteed minimum withdrawals. Be sure to inquire about any fees associated with the available riders.
- Make sure your broker is a fiduciary. Some brokers receive compensation for sales of certain annuity sub-accounts, which could influence your investment choices. A fiduciary is legally required to make investments in your best interest, regardless of the financial benefits for them.
- Choose a deferral period based on your savings and liquidity needs. This is the minimum amount of time you have to hold the annuity during the accumulation phase without paying a surrender penalty. Deferral periods typically range from 3 to 15 years but can be longer.
- Sign the annuity contract when you are confident you’ve found the right product and provider.
- Select your annuity sub-accounts and begin making premium payments.
Take the Next Step
Variable annuities aren’t for everyone. They offer high potential returns, plus benefits like tax deferral and optional riders, but also the risk of losing your premium. Like all important decisions, take your time and make sure your chosen annuity matches your income, investment goals, and retirement timeline.
For personalized guidance on annuities and help creating a secure retirement, reach out to one of our licensed agents today.
