Confused about variable annuities? Maybe you read an article about 10 reasons why variable annuities are great investments. Or maybe you just read an article about 10 reasons why variable annuities are terrible investments.
The truth is variable annuities are a financial tool designed for a job. Whether they are good investments or bad investments depends on what job you want them to do.
Talk to a local independent insurance agent. They can help you decide if a variable annuity is right for you.
What Are Variable Annuities?
Annuities are policies issued by insurance companies. They pay a regular guaranteed income for life or a period of years. You buy a variable annuity contract by making a single payment or a series of payments.
Deferred annuities accumulate money for a period before the policy pays income. Deferred variable annuities accumulate money in investments selected by the owner, called subaccounts. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They aren’t guaranteed.
Qualified variable annuities are part of a pension plan or IRA. They are purchased with before-tax dollars. Non-qualified annuities are personally owned and paid for with after-tax dollars.
|Account Value||Cash value of annuity before surrender charges|
|Accumulation Phase||Period when purchase payments are made and money is accumulated in subaccounts|
|Accumulation Unit||Measure of variable annuity account value|
|Asset Allocation||Distribution of purchase payments across asset classes, stocks, bonds etc.|
|Asset-Based Fees||Fees and expenses calculated as a percentage of the account value|
|Capital Gains Rate||Federal tax rate applied to long-term capital gains|
|Cost Basis||Sum of annuity purchase payments|
|Distribution Phase||Period when income is distributed on a regular basis. Also known as payout phase.|
|Gain||Account value in excess of purchase payments|
|Investment Manager Fees||Professional management fees for subaccount funds|
|Living Benefits||Optional variable annuity features that protect against investment risk|
|Mortality and Expense Fee||Charge for providing guaranteed death benefit and lifetime income rates|
|Ordinary Income Rates||Federal tax rates applied to wages, salaries, tips, commissions, and other types of income.|
The ordinary income rate does not apply to long-term capital gains.
|Penalty Tax||10% federal tax on annuity, IRA and qualiifed plan withdrawals before age 59-1/2|
|Rebalancing||Realigning asset class allocations within a portfolio|
|Subaccount Funds||Investment funds offered in a variable annuity|
|Surrender Charge||Charge for withdrawals during the surrender period, usually 5-7 years.|
|Surrender Value||Account value minus surrender charges|
What’s Good about Variable Annuities?
Variable annuities accumulate money on a tax-deferred basis. Money can be transferred between subaccounts without any tax consequences. Non-qualified variable annuities have no contribution limits, unlike IRAs and qualified plans. A portion of regular payments received from variable annuities is excluded from taxable income.
Variable annuities have living benefits that offer “downside protection” to investors during down markets.
A guaranteed minimum accumulation benefit guarantees a minimum account value regardless of investment performance. The minimum is usually 100% of the purchase payments after a 7-10 year holding period. There is a charge for this feature.
A guaranteed minimum income benefit (GMIB) rider provides a minimum amount of lifetime income at retirement regardless of what the account value is. The minimum income is the original investment accumulated at an interest rate specified in the policy. Once the option is selected, the owner has no access to policy values. There is a charge for this feature.
A guaranteed lifetime withdrawal benefit (GLWB) provides a minimum amount of lifetime income at retirement regardless of the account value. Unlike a GMIB, the owner does have access to the account values. Withdrawing money in excess of the guarantee will reduce or eliminate the minimum income. There is a charge for this feature.
Variable annuities provide guaranteed income.
The regular guaranteed income is payable for the lifetime of one person, the longer lifetime of two people, or a specific period of years. Guaranteed income protects you from outliving your money.
Variable annuities have death benefits to protect beneficiaries.
If you die before receiving guaranteed income, your beneficiary will receive a death benefit. Usually the death benefit is the greater of your account value and the amount of your purchase payments.
Some life insurance companies offer death benefits that step up or increase based on a formula. The formula can be the greater of the purchase payments accumulated at an interest rate. The formula can also be based on the highest previous account value. There is a charge for this feature.
Variable annuities are protected from creditors.
Most states offer variable annuities some form of creditor protection. In some cases, this is unlimited.
What’s Bad about Variable Annuities?
Variable annuities can be expensive.
Depending on the insurance company and features selected, the fees and expenses can be upwards of 3%.
Variable annuities are not as liquid as other investments.
Most variable annuities have surrender penalties for the first four to seven years of the contract. Surrender penalties apply to withdrawals in excess of 10% of the account value. A 10% federal excise tax is imposed for withdrawals before age 59 1/2
Distributions from variable annuities that are not regular payments are taxed at ordinary income rates until there are no gains left in the contract. Loans from non-qualified annuities are distributions with tax effects. Variable annuity gains are taxed at ordinary rates. Most long-term investment gains are taxed at the lower capital gains rate.
When Are Variable Annuities “Good” Investments?
Variable annuities are insurance products. They can offer protections and certainty. Between October 2007 and March 2009, the stock market lost 50% of its value. It took 4 years, until March 2013, just to get back to where it was.
Were variable annuities with living benefits good investments to have at that time? For investors who wanted certainty, the answer is probably yes.
No load/low cost variable annuities are potentially a good idea for investors who frequently rebalance their portfolios. Transfers between variable annuity subaccounts do not trigger taxable income.
When Are Variable Annuities “Bad” Investments?
Variable annuities are designed to be long-term investments, to meet retirement and other long-range goals. Variable annuities aren’t a good choice if you don't have other investments to meet emergency and other short-term needs.
Taxes, penalties and insurance company charges may apply if you withdraw your money early. Remember, variable annuities also have risk like mutual funds and other investment products do.
There are no tax benefits to using a variable annuity in your IRA or pension plan. The only benefits are the protection features they offer. The features of variable annuities, living benefits and death benefits come at a cost. If those features are not important to you, then consider other alternatives.
Why Do It Yourself?
Variable annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. Talk to your independent insurance agent. They can help you decide if a variable annuity is right for you.
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The advisor’s guide to annuities, John Olsen
Insured Retirement Institute
IRS Pub 575
IRS Pub 410
NAIC variable annuity Buyers Guide
SEC guide to Variable Annuities
Finra guide to Variable Annuities
The American College of Trust and Estate Counsel State Survey of Asset Protection Techniques