Variable Annuities

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If you are near to your retirement and worried about the possibility of outliving your savings, this is the best time to plan your retirement income stream. Variable annuities thus come into play. In its simplest form, a variable annuity is a tax-deferred retirement instrument giving a person a choice to select from a range of investments, which pays an income stream in retirement. This income is tied to the performance of the investments chosen. Unlike other financial instruments and tools, variable annuities give the power of both investing (tax deferral and flexibility) and insurance (legacy protection and income guarantees) in one exclusive retirement product. The article discusses what variable annuities are, how they work, how to select the right one, and the pros and cons.

What is Variable Annuity?

As its name suggests, a variable annuity has the rate of return that changes with the bond, stock, and money market funds that a person selects as his investment options. Variable annuities are often compared to mutual funds since they provide similar investment features, including investment choices—termed as “separate accounts”—like mutual funds. However, they are not identical. 

A standard variable annuity provides the following fundamental features that mutual funds don’t have:

  • tax-deferred treatment of the earnings
  • death benefits for legacy planning
  • annuity payout alternatives (annuitization) that give guaranteed lifetime income

While variable annuities benefit from tax-deferred growth, their yearly expenses are often considerably higher than those in a typical mutual fund. And, contrary to the fixed annuity, variable annuities are deprived of any guarantee about a particular return on investment. Instead, it carries a risk of losing money. 

In general, variable annuities deal with two phases: 

  1. The “accumulation” phase, when premiums paid are assigned among investment portfolios, or the subaccounts, and the earnings on these investments accrue
  2. The “distribution” phase, if the insurance company guarantees a minimum payment based on the principle and investment returns (positive or negative).

In the accumulation phase, it might be expensive and difficult to access the money invested. You often need to pay “surrender charges” for early money withdrawal—and you might be under some tax liabilities on the earnings your investment has produced.

During the distribution phase, you generally have the option to withdraw money either as a lump sum or as a series of payments with time. Irrespective of the fact, your distribution is based on the performance of chosen investment options.

How Variable Annuities Work?

As explained before, a variable annuity has an accumulation phase and a distribution (annuitization) phase.

In the accumulation phase, a person makes purchase payments. The money in the account becomes allocated to various investment options—usually mutual funds—that a person selects. The insurance company deducts fees from purchase payments.

Moreover, you can assign part of the purchase payments to some fixed account. A fixed account, as opposed to a mutual fund, pays a fixed rate of interest. The insurance company might intermittently reset this interest rate, but it generally provides some guaranteed minimum (1-3% per year).

The money held in the account will differ from the premiums paid, as per the amount of the contract fees and expenses, and how the chosen investment options perform. 

Expenses & Fees Involved

Variable annuities usually have high annual expenses and fees, in addition to possible sales and surrender charges as well as withdrawal penalties. These include:

  • The insurance company charges mortality and expense risk charges to cover definite death benefits, annuity payout options offering guaranteed income for life, or guaranteed caps over administrative charges.
  • Administrative fees for documentation, record keeping, and other admin expenses.
  • Underlying fund expenditures related to the investment subaccounts.
  • Charges for exclusive features, like stepped-up death benefits, long-term health insurance, guaranteed minimum income benefits, or principal protection.

You need to ensure that you understand all the expenses, fees and other charges about the variable annuity suggested to you before making a purchase.

Who Should Buy Variable Annuity?

Variable annuities are ideal for people who seek a more substantial potential payout than a fixed annuity offers — and people are willing to take on a certain level of market risk.

Variable annuities also help diversify these people’s retirement investments and grow their money tax-deferred. It may be an excellent alternative if they have already maxed out their annual 401(k) contributions.

This kind of annuity is typically suggested for younger investors with longer time horizons and a willingness to high-risk tolerances.

Variable annuities might also be an attractive choice if you need more control over your investments since you can choose and select your underlying bonds and stocks. 

The Bright Sides of Variable Annuities

Variable annuities offer the following key benefits:

  1. Potential Inflation hedge

If your investment portfolio works well, you gain the potential to experience an increase in your payments, letting you better keep up with the inflation.

  1. Tax deferral

You don’t need to pay taxes on earnings until you get the money out of the annuity.

  1. Initial investment protection

Typically, the annuity provider will guarantee you access to your invested money even if you make zero interest in case of a poorly performing portfolio.

  1. Death benefit

 If you die before receiving payments, your beneficiary will get a payout from the annuity company.

  1. Lifetime Payments

You have the choice of getting payments for the rest of your life, even if the portfolio performs unsatisfactorily and you finish your principal investment (through annuitization process). Although, you might need to pay additional for this option.

The Down Sides of Variable Annuities

Variable annuities offer the following disadvantages:

  1. Return is not guaranteed 

Unlike fixed and equity-indexed annuities, you don’t have a guarantee that you will earn interest on the investment. If your investment portfolio works poorly, it will impact the value of your annuity. It may even go negative on a poorly performing portfolio.

  1. Taxed as income

 The earnings are taxed as income when you withdraw the money, not at the desired capital-gains rate.

  1. Complexity

Since variable annuities are complicated, some investors might become confused about the variable annuities’ provisions. This has resulted in what regulators say are questionable sales practices that make variable annuities a key source of investor complaints.

  1. Surrender charge

A surrender or withdrawal is charged if you take a partial or full amount of money out of your annuity earlier than the term allows. This charge may be as high as 10% early in the contract. Some annuities let investors withdraw slight amounts – usually 10 percent or less – annually.

  1. Mortality and expense risk charge

Charge for covering the guaranteed death benefits, guaranteed income for life, or guaranteed caps on the administrative charges: this fee is usually 1.2% or higher, charged annually.

  1. Administrative Fees

These cover the record-keeping and other administrative costs.

  1. Sales commission

The agent who sells the annuity might receive compensation for the sale.

  1. Primary fund expenses

Cover the costs of the subaccounts where money is invested. It can be over 1 percent a year.

What is the Free Look Period?

Most variable annuity contracts contain a “free look” period of 10 or more days where the investor can cancel the contract without paying any surrender fees.

If you decide to cancel the contract, the annuity company returns your premiums. The amount might be affected based on the performance of your investments during that period.

Exchanging or Replacing Current Annuity

If you have already bought a variable annuity, you might be presented with an alternative to exchange or swap it. There can be paybacks to what is called a “1035 exchange,” which is the provision in the U.S. tax code allowing the direct transfer of funds in a life insurance policy, endowment policy, or annuity policy to another policy with no tax consequences.

If you need to exchange or replace your annuity, make sure to have a close comparison first with your current annuity, and just make a change when it is better for you, and not just better for the person attempting to sell you the new product. Remember that exchanging one contract for a new one typically means the clock re-starts for early withdrawal penalties.

Final Thoughts

A variable annuity is good for you if you are willing to take the risk to earn a higher return. It provides more control over your investment, greater customization, and independence. A variable annuity has the highest earning “potential” among all annuities. Go for the variable annuities if you have a longer investing timeline, don’t have many withdrawals for years, have significant time to wait out any short-term losses. Although you must keep in mind that if your sole purpose is taking a market exposure, Variable Annuities may not be the best route to take because of their high costs compared to other strategies such as Index Funds, or ETFs.

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