Are Variable Annuities a Good Investment for Retirement?

Are variable annuities a good investment?

Well, maybe! If you are simply seeking a solid investment with healthy returns and low fees, a variable annuity may not be the best choice.

Why? One of the big advantages of an annuity is that your money grows tax-deferred, meaning you won’t owe income taxes until the annuity payments begin.

But you can get that tax deferral through a traditional individual retirement account (IRA), so there's no tax advantage to holding a variable annuity contract over an IRA that holds stocks or mutual funds. Most IRAs have lower administrative fees than a typical variable annuity.

Also, variable annuities tend to be "expense heavy." This means that the insurance company charges you fees for managing the investments in the sub-accounts that are the hallmark of the product. But variable annuities aren't all bad.

If you are planning to use the money from a variable annuity to create a stream of guaranteed payments in retirement, and are looking for maximum growth of principal, a variable annuity may be a good choice.

Let's review the basics of variable annuities and see if this product may have a place in your retirement plan.

What Is a Variable Annuity?

A variable annuity is a contract between you and an insurance company. The product features an investment account that can grow your money on a tax-deferred basis.

It also includes insurance features, like the ability to turn the money in your account into a stream of periodic payments in retirement.

You purchase a variable annuity by making either a single payment (a single premium variable annuity) or a series of purchase payments (a flexible premium variable annuity).

The product also offers a choice of investment options, which makes it different from fixed-indexed annuities or fixed annuities, which are more conservative varieties of annuities (more on these products in a minute). The value of your contract will vary depending on the performance of the investment options you choose.

The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, and money market instruments or some combination of the three.

This means that variable annuities can have the biggest upside growth compared to other annuities. It also means that there is a greater risk of losing money.

How Variable Annuities Work

Like all deferred annuities, variable annuities have two "phases." They are the accumulation phase and the payout phase.

Let's review the basics of how these products work.

During the accumulation phase, you deposit premium(s) to fund the annuity. This premium will grow or shrink depending on the performance of the sub-accounts you chose. Your initial account value may actually be less than what you deposited because the insurance company assesses fees right from the start of the contract.

Your hope is that the performance of the underlying investments during the accumulation phase will overcome any fees charged. The money you deposit is invested in a menu of investment options that you choose, typically mutual funds.

This allows you to adjust the investments to match your risk appetite.

To alleviate some of the risk inherent in variable annuities, the insurance company may make a fixed account available as part of your investment choices.

Companies also offer added value features like death benefit provisions. For every added feature, there may be associated costs that can reduce your returns. Make sure you ask your financial professional about all fees.

The payout phase begins if you choose to “annuitize” your contract. If you annuitize, you can choose to receive the amount of money accumulated in your contract as a stream of income payments.

These payments are usually paid monthly. Most contracts offer you choices of how long your payments will last.

Under most annuity contracts, you can choose to have your income payments last for a period of time that you choose (such as 20 years) or you can choose to receive lifetime income.

This feature is the primary benefit of purchasing an annuity. There are even features that allow payments to be paid for the lifetime of both you and your spouse.

Finally, you may be able to choose fixed income payments that are guaranteed by the insurer or payments that may vary based on the performance of investment options.

Once again, you should choose the option that matches your unique financial situation and risk tolerance and take into consideration the risk profile of other assets that make up your retirement portfolio.

The amount of each periodic income payment will depend, in part, on the time period that you select for receiving payments. Remember that once the stream of payments starts, you usually cannot make any other withdrawals from the account.

So far, we have been talking about deferred variable annuities, where you are allowing value to build up in the account before distributing money to yourself. Some annuity contracts are structured as immediate annuities.

This means that there is no accumulation phase and you will start receiving income payments shortly after you purchase the annuity.

Pros and Cons of Variable Annuities

Pros:

• Higher earnings potential compared with other types of annuities, and growth is tax-deferred. Any gains, including dividends, aren’t taxed until money is paid out.
• Money can be transferred among sub-accounts without any tax penalties.
• Unlike IRAs and qualified retirement plans, there are no limits to the amount of money you can deposit per year for annuities.
• All types of annuities protect you from outliving your income. Variable annuities have features called living benefits that offer a guaranteed minimum income regardless of investment performance.
• Variable annuities have death benefits to protect beneficiaries.
• Variable annuities are protected from creditors as they are considered insurance products and not assets. As long as you name a beneficiary, you will avoid probate upon the death of the owner/annuitant.

Cons:

• Higher risk of losing money than other types of annuities.
• Other investment choices, like stocks and mutual funds, may offer higher returns with lower annual fees.
• Variable annuities feature the highest administrative expenses among all types of annuities because you are carrying costs for insurance and investment features.
• Like most annuities, variable annuity contracts have early withdrawal penalties, known as surrender charges.
• Distributions from variable annuities that are not regular payments are taxed at high ordinary income rates (vs capital gains rates).
• The complexity of these products can make them difficult to understand.

Variable vs. Fixed Annuities

There are benefits and drawbacks with all types of annuities, but if we are comparing variable annuities to fixed annuities, there are some key differences:

You might consider a variable annuity:

• If you want the potential of earning higher returns than other annuities.
• If you have some expertise as an investor and are confident in your ability to choose investments.
• If you're comfortable with higher-risk investment options.
• If you’re okay with possibly losing money.

When to consider a fixed annuity:

• If you want guaranteed returns on your principal.
• If you want to almost entirely eliminate your investment risk.
• If you enjoy the confidence of knowing your money will grow steadily, if not spectacularly.
• If you like being able to calculate the future value of your retirement account.

When Are Variable Annuities a Good Investment?

If you're simply looking for a product to help meet your investment objectives in retirement, and are not interested in creating a stream of guaranteed lifetime income, then a variable annuity may not be the best choice. If, however, you are comfortable with managing market risk and are interested in the income guarantees that are inherently part of the structure of annuity products, then variable annuities may have a place in our overall insurance and investment portfolio.

This is especially true if you are young and healthy and can weather the ups and downs of investment markets. If, however, you are more attracted to fixed returns that are guaranteed by the insurer and also offer tax-deferred gains and the option of lifetime income, a fixed annuity is likely a better choice.

Fixed annuities can be a valuable, conservative foundational product that can complement riskier investments. The crediting rates can also significantly outpace similar products including CDs and savings accounts.

Bottom Line: Is a Variable Annuity Right for You?

So, a variable annuity might be right for you if you are comfortable with market risk, have a long time horizon, and are eventually looking to create a stream of income in retirement.

But if you are looking to add a product with guaranteed interest rates paid to you for a specific period of time, then a fixed annuity may be a better choice. Is there room for both products in your portfolio?

Of course! Any great retirement portfolio features a mix of investments, risks, and product features. But fixed annuities can present a solid, conservative base for your retirement plan.

Canvas annuities offer customer-friendly fixed annuity products at market-leading guaranteed rates.

The application takes only a few minutes and the entire process can be completed 100% online or via a friendly contact center agent.