Variable annuities offer strong growth potential and considerable risk all at once. Because the returns you earn through a variable annuity are based on the performance of an investment portfolio, you stand the chance of losing money. However, there are a few limitations on how much you can earn with a variable annuity, which makes them undoubtedly enticing.
Whether a variable annuity is a good idea for you is a deeply personal decision, as it completely depends on your needs. If you have specific questions about annuities or retirement planning, reach out to a financial advisor.
Variable annuities are an option that may provide both, but that doesn’t mean they’re the best choice for everyone. Understanding the potential advantages and disadvantages of a variable annuity can help you decide if one might fit into your retirement plan.
How Does a Variable Annuity Work?
A variable annuity is an insurance contract where you invest money into subaccounts tied to the market. During the accumulation period, a time when you save and potentially grow the value of your annuity to prepare for your retirement needs, your annuity’s contract value will rise or fall based on the performance of the underlying investments you selected.
Later when you’re ready to retire, you can convert the value of your annuity into a stream of payments that can last for your entire lifetime. Higher gains during the accumulation period will translate into higher future payments, while lower gains, or losses, will result in smaller payments.
A variable annuity starts with you making payments to an insurance company and choosing funds to invest your money in. By purchasing an annuity, you’re taking on an insurance contract that provides income for retirement based on how your investments perform.
All annuities have two components: the principal you pay into it and the returns on that principal. Generally, you pay a lump-sum premium into the policy or you pay over a period of time. Variable annuities are deferred, as buyers typically wait years to begin taking payments.
The “variable” in a variable annuity refers to its potential returns and investment selection. You invest the funds in your variable annuity in one or more funds, most of which are mutual funds that focus on specific areas of the market. Because of the volatility any investment can experience, the value of your account can rise and fall with the market. You may lose money, but you might also earn quite a bit. This is in contrast to a fixed annuity, which operates like a certificate of deposit and earns a set interest rate.
Once you retire, you can turn your principal and earnings into a stream of income for a set period of time or for life. If you die before you annuitize (receive all the payments of your annuity), the insurance company will typically guarantee a death benefit payment to your beneficiaries of at least what you put in, minus any withdrawals and taxes. In exchange for all these benefits, however, there are steep fees and costs.
More specifically, variable annuities have the most extensive fee structure of any annuity type. They often feature some combination of contract fees, investment fees, mortality and expense risk fees and more.
Total fees can have a significant impact on your returns, ranging from 2% to 3% and higher. So, if you have a $100,000 variable annuity with an annual fee of 3%, you would pay $3,000 in fees each year. And if your annuity returns 5.55% in a given year, you would only see a net return of 2.55% or $2,550 after fees.
These charges can add up over time, which only takes away from your potential growth. However, what you’re betting on with a variable annuity is that you’ll be able to outperform those extra costs so you still come out ahead.
Read Also: Understanding Variable Annuities: A Beginner’s Guide
To protect against losses, an insurance company will offer guarantees for an additional cost. For example, you could pay extra for a rider that will lock in earnings for 10 years so they will be part of the calculation when you annuitize. These riders allow you to customize your contract so it fits your plan better.
Pros of Variable Annuities
There are many pros and cons to annuities and more specifically, variable annuities. The biggest benefit of a variable annuity is the potential growth your money could earn. Compared to many other types of annuities, such as fixed annuities, a variable annuity potentially offers the best possible return. This is because your money is in the markets. Here are the other major benefits:
- Money grows tax-deferred: Another benefit, which is true for all annuities, is that your money grows tax-deferred. So the money you would have paid to the IRS stays in your account and can grow even more. You won’t owe income taxes until you make a withdrawal or start receiving payments from your variable annuity.
- Lifetime income: Additionally, as with all annuities, a variable annuity offers a protected lifetime stream of income. For many, the knowledge that they won’t outlive their money gives them great peace of mind. If you live longer than the actuaries predict and your account is empty, the insurance company will still send you regular payments for as long as you live.
- Protected funds: The money in an annuity is protected from any creditors you may have since the insurance company actually has the money. This makes an annuity one of the safest investments available.
Cons of a Variable Annuity
Before you rush out to buy a variable annuity, you should be aware of the drawbacks of this retirement savings vehicle. Here are the most important things to be aware of that might be a negative for your situation:
- Overall cost: A variable annuity’s biggest disadvantage is its cost. Variable annuities can charge high fees. These include administrative fees, fees for special features and fund expenses for the mutual funds you invest in. And then there are the sales commissions.
- Risk fees: Also, there’s the mortality and expense (M&E) risk charge. This charge, generally around 1.25% of your account value, is charged annually as compensation to the insurance company for taking on the risk of insuring your money. When you add up these fees and charges, variable annuities can be a pricey place to store your money.
- Low return potential: A variable annuity may provide a lower return than the other kinds of annuities. It all depends on the markets. If they’re down, so is your money.
- Lack of access: If you have yet to reach retirement, variable annuities, or all annuities for that matter, are virtually inaccessible. This is because of the surrender charges that insurance companies institute in these contracts. That means any withdrawals made during that time that are above the amount you’re allotted will incur an extra charge of sometimes up to 10%.
Variable annuities come with tax advantages, but they can be expensive. Ideally, you should max out your contributions to your 401(k) and IRA before putting money in an annuity of any kind. That’s because annuities are much more advanced products, which makes them better as secondary savings options. Of course, if you’re already maxing out your 401(k) and IRA contributions, a variable annuity could be worth it.
If you have a 401(k) and you fund your variable annuity with pre-tax dollars from it, you’re not maximizing the tax benefits. For the most tax-deferred growth, you should put any savings outside of your 401(k) balance in the annuity. Of course, if your company offers an annuity in your 401(k), you could do both.
Variable Annuity or Fixed Annuity
While a variable annuity earns returns through investment performance, a fixed annuity grows via a specific interest rate that the insurance company presets. The market can also dictate the quality of these fixed rates, though.
As you might expect, a standard interest rate likely won’t ever outperform investments. That’s because mutual funds and other securities have exponential growth opportunities, whereas the fixed rate market is considerably more stagnant. In good market conditions, a fixed annuity’s interest rate might hover around 3%. However, in 2023, interest rates ranged from 4% to 5% and more.
If you’re wondering why investors would get a fixed annuity, it boils down to risk and fees. There’s minimal volatility in the fixed rate market, which can be enticing, especially for those close to retirement who already have a sizable pool of savings. In addition, while variable annuities charge a multitude of fees, fixed annuities often have no annual fees whatsoever. On occasion, an insurance company might allow you to buy an extra rider, though.
In the end, variable and fixed annuities are versions of the same thing, so they share many of the same benefits. Tax-deferred growth is perhaps the most important among these similarities. In fact, they both allow your funds to grow without incurring income taxes. Then, once you retire, you’ll pay income taxes on your withdrawals.
Beyond that, death benefits are available for both fixed and variable annuities during the accumulation phase of a contract. Therefore the contract owner’s assets are protected in both cases should they pass away earlier than expected.
What are the Pros and Cons of Investing in Annuities?
When you purchase an annuity, you hand over a lump sum of money or a series of premium payments to an insurance company. In exchange, the insurer promises to pay you a series of payments now or in the future. Those payments can last for a specific number of years or for the rest of your life — no matter how long you live. Money invested in an annuity grows tax-deferred, meaning you’re taxed upon withdrawal or when payments begin.
Annuity contracts are highly customizable. Critics might argue this is what makes annuities so confusing. There are numerous riders available, each offering different features and each driving up the overall cost and complexity of an annuity contract.
The main types of annuities are:
- Variable annuities. Premium payments into a variable annuity are invested in one or more sub-accounts which are similar to mutual funds. The value of the annuity is determined by the performance of investments in those accounts.
- Fixed annuities. A fixed annuity guarantees a minimum rate of return. The rate can be reset periodically over time or increase annually.
- Indexed annuities. An indexed annuity tracks an index like the S&P 500 and offers a capped return based on the total returns of the index. Indexed annuities generally offer a minimum level of return as well.
Some annuities are immediate, meaning that annuity payments can begin within a year or less after the premium is paid. Others are deferred annuities, meaning that payments begin at some point in the future, as stipulated in the annuity contract.
Pros of annuities
- 1. Regular payments
In an era when employer pensions have gone all but extinct in the private sector, annuities can offer contract holders the opportunity to receive guaranteed monthly payments. These payments can provide regular, dependable income through retirement, or provide a bridge to Social Security if you chose to retire early.
- 2. Lifetime income
Annuities can be structured to provide regular payments for the rest of your life — no matter how long you live. Not outliving your savings is a huge advantage touted by annuity providers. While anyone’s actual life expectancy is almost impossible to predict, the fear of running out of money in old age is a real concern for many Americans.Just keep in mind to secure a lifetime of guaranteed income, you’ll likely need to purchase a rider.
- 3. Tax-deferred growth
Money inside an annuity grows tax-deferred. Gains on the amount of premium invested in the contract grow with no taxes due until the money is withdrawn, assuming the annuity is non-qualified, meaning that it’s not held inside an IRA or other retirement account.
If money is withdrawn in lump sums, it’s considered a withdrawal of capital gains first, making it fully taxable. In contrast, only a part of regular annuitized payments are subject to tax, because a portion of the payment is considered a return of the cost basis (and so not taxable) while the rest are taxed as capital gains.
- 4. Guaranteed rates of return
Some annuity contracts, typically fixed annuities and indexed annuities, offer guaranteed rates of return. While your rate of return on these annuities can be higher than the minimum, it’s nice to know there is a floor on the rate of return, too. However, sometimes this floor can be a loss instead of a gain.
- 5. Survivor benefits
Annuity contracts offer several options for survivors of the contract holder, though they vary from insurer to insurer. The contracts will typically offer an option to designate beneficiaries in the event of the account holder’s death.
In addition, annuities may offer options that allow survivors to continue to receive payments upon the annuitant’s death. This might be a joint and survivor option for a spouse or a “period certain” option for a non-spousal beneficiary.
Cons of annuities
- 1. High expenses and commissions
Cost is one of the biggest drawbacks of annuities. Expenses erode the owner’s returns, especially on a variable annuity where the value depends on the investment returns. Some annuity contracts are so complex that the full rate of the internal expenses is hard for the average person to understand.
Annuities are typically sold by insurance agents, not financial advisors. That means they earn a commission on the products they sell you. While the commission is usually baked into the annuity contract, it can amount to anywhere from 1-10 percent of the total value of your contract.
- 2. Difficult to exit
While it may be possible to get out of an annuity contract, it comes at a cost. Some insurers make it difficult to exit an annuity by imposing high surrender charges. These charges might amount to 10 percent or more of the value of the contract. Typically, the surrender charge will decline over time.
And you’re not able to get out of the contract whenever you want, since annuities typically have a limited surrender period. These periods usually last six to eight years after purchasing the annuity, but it depends on the contract.
- 3. Possibility of an insurer defaulting
Annuities are guaranteed by the insurance company that issues the contract. While there have not been a lot of defaults on annuities, it can still happen. The backup to the insurance company is your state’s guaranty association. It is a good practice to check on the financial solvency of an insurer before purchasing an annuity contract.
- 4. Highly complex
The contractual language in an annuity is complex, making it difficult for the average person to understand what their rights and responsibilities are and what they’re getting for their money. Annuities can differ markedly from one another, making it difficult to compare them.
Worse, because sales people earn a commission by selling annuities, they are not incentivized to highlight all the fine print or risks to potential buyers.
Conclusion
Variable annuities can be pricey, and if that turns you off of them then you may want to consider investing on your own through a brokerage account. Although you’ll miss out on the tax-deferred growth, your fees will be much lower. Then when the time comes to retire, you can buy an immediate annuity if you want the lifetime income stream. If not still not sure then you can work with a financial advisor to help make that decision.