Variable Annuities: a Good Retirement Investment?

Reviewed by Margaret JamesReviewed by Margaret James

One of the biggest worries you might have about your retirement is the prospect of outliving your assets. With many people in the developed world now living 20 or more years past retirement, those fears may be justified. That’s why some individuals opt to purchase variable annuities in order to achieve a fixed stream of payments and tax-deferred growth.

How Annuities Work

Annuities have long been a popular strategy for managing this so-called “longevity risk.” A standard fixed annuity is an insurance contract that allows an individual to pay premiums—either in a lump sum or by monthly installments—and obtain set income payments for life.

However, one drawback for some consumers is the modest rate of growth earned on the contributions. Historically, the internal rate of return has been close to long-term Treasury bond yields, often in the low single digits. In other words, you’re lucky if the money you put in keeps pace with inflation.

One alternative is the variable annuity. With a variable annuity, you select multiple sub-accounts, which are essentially mutual funds that invest in stocks, bonds, and other instruments.

Typically, a person contributes money to the annuity during their working years—called the accumulation phase. As contributions are made, the funds are invested with the goal of building up enough money to have adequate income in retirement. The more money invested during the accumulation phase, the more will be received when withdrawals are taken in retirement. The value of your account—meaning the amount of your payments during the withdrawal phase—also depends on the performance of the underlying investments. 

Those who pay in for a long-enough period before making withdrawals often do better than they would have with the fixed returns they’d otherwise receive. That’s particularly true if they select investments that suit their age and financial goals. However, if the markets take a dive, there’s also the possibility that your account could lose value.

Pros and Cons

Variable annuities share certain features with individual retirement accounts (IRAs) and 401(k) plans, including tax-deferred growth. As a result, you can hold off paying taxes on gains until you start receiving payouts. (Like these other retirement plans, you normally can’t make withdrawals before the age of 59½ without incurring a 10% penalty.)

Annuities may also provide benefits that other retirement vehicles don’t have, such as a death benefit for loved ones. Typically, the person you select as your beneficiary will receive either the balance of your account or a guaranteed minimum payment. 

Unfortunately, annuities also have some less-appealing characteristics. Among them is less-favorable tax treatment once you hit the annuitization phase. Any growth in your annuity above and beyond your contributions is treated as ordinary income. If you’re in a higher tax bracket, that aspect alone can take a huge bite out of your earnings.

Further eroding your account are the notoriously high fees that insurance companies charge their annuity customers. You’ll really feel the squeeze if you take money out of the policy within the first few years and incur a surrender charge. The amount of this fee is usually based on the amount you withdraw, with the percentage gradually decreasing over a period of several years. For example, taking funds in year one may incur an 8% charge, while a withdrawal in year eight only takes a 1% hit.

Figure 1. Example of surrender charges associated with a variable annuity

Even if you don’t take money out during the surrender period—anywhere from six to 10 years after signing up, depending on the annuity—you still face pretty stiff annual fees. These can include:

• Mortality and expense-risk charges: These offset the risk that the insurer’s customers will live longer than expected.
• Underlying fund expenses: These cover the cost of managing funds within the annuity.
• Administrative fees: These compensate the carrier for record-keeping and other expenses associated with servicing the contract.

According to the Financial Industry Regulatory Authority (FINRA), these yearly expenses can easily total 2% or more of the annuity’s value. And if you’re looking for additional features with your variable annuity, such as a guaranteed-minimum-income benefit or a stepped-up death benefit, you’ll probably confront even higher fees.

Warning

By contrast, many investment companies offer index funds with fees less than 0.50%. Even actively managed funds look comparatively cheaper than annuities, with average expense ratios of around 1.25%. 

Are Variable Annuities Ever a Good Idea?

Where variable annuities may be worth a look is if you’ve maxed out your contributions to other tax-advantaged accounts. If that’s the case—and you want the peace of mind that lifetime payments provide—these insurance contracts merit some consideration. Your best bet is searching for one with relatively low costs from an established company with a strong financial rating from agencies such as A.M. Best and Moody’s.

Should You Put an Annuity in a 401(k)?

Because of the additional costs that annuities tend to incur, experts generally advise against putting these contracts inside an IRA or a 401(k). These plans already offer tax-deferred growth; there’s no point in doubling up on this benefit.

Why Would Someone Choose a Variable Annuity Over a Fixed Annuity?

Variable annuities have the potential for higher returns than fixed annuities, which may not even keep up with inflation. However, with a variable annuity, there’s a chance that you’ll lose money on the investment.

The Bottom Line

On the surface, variable annuities look like an attractive way to plan for retirement, with tax-deferred growth, payouts for life, and even a death benefit for your family. However, because other retirement accounts, such as IRAs and 401(k)s, offer the same tax-deferred growth with lower fees, most people will probably want to start there.

Read the original article on Investopedia.