An In-Depth Guide to Annuities: Variable Annuities

As individuals seek to build a robust retirement plan, variable annuities have become a popular investment choice. Unlike fixed annuities, which provide a predetermined and consistent rate of return, variable annuities offer the potential for higher returns through investments in the stock market. This guide will explore the fundamentals of variable annuities, their advantages and disadvantages, and factors to consider when deciding whether a variable annuity is the right investment choice for your retirement planning needs.

What is a Variable Annuity?

A variable annuity is a contract between an investor and an insurance company. The investor makes a lump-sum payment or a series of payments to the insurance company. In return, the insurance company agrees to make periodic payments to the investor, either immediately (in the case of an immediate variable annuity) or at a specified future date (in the case of a deferred variable annuity). Unlike fixed annuities, the return on a variable annuity is not guaranteed. It depends on the performance of the underlying investments, typically a selection of mutual funds, stocks, and bonds.

There are two main phases in a variable annuity:

1. Accumulation Phase: During this period, the investor makes contributions to the annuity, and the funds are invested in a range of subaccounts chosen by the investor. The subaccounts invest in various asset classes, such as stocks, bonds, and money market funds. The value of the annuity will fluctuate based on the performance of these subaccounts.
2. Payout Phase: When the investor decides to start receiving payments from the variable annuity, they enter the payout phase. The payments can be structured in various ways, such as a fixed period, a specific amount, or a lifetime income stream. The amount of the payments will depend on the performance of the subaccounts during the accumulation phase.

Benefits of Variable Annuities

1. Growth Potential: One of the primary advantages of variable annuities is their potential for higher returns due to their exposure to the stock market. This growth potential makes them an attractive option for investors seeking to outpace inflation and achieve higher returns than fixed annuities.
2. Tax-Deferred Growth: Like fixed annuities, the interest earned on a variable annuity is taxed once the investor receives payments. This tax-deferred growth allows the investor’s money to grow faster, as it is not subject to taxes during accumulation.
3. Lifetime Income: Variable annuities can provide a guaranteed income stream for the investor’s life. This feature ensures that the investor will not outlive their retirement savings, providing financial security and peace of mind.
4. Investment Flexibility: Variable annuities offer investors the flexibility to choose from a wide range of investment options, allowing them to tailor their investment strategy based on their risk tolerance and financial goals.
5. Death Benefit: Many variable annuities include a death benefit, which guarantees that the investor’s beneficiaries will receive a specified amount, usually the initial investment, in the event of the investor’s death.

Drawbacks of Variable Annuities

1. Investment Risk: Unlike fixed annuities, the return on variable annuities is not guaranteed and depends on the performance of the underlying investments. This exposure to market fluctuations and potential for loss makes variable annuities more suitable for investors with a higher risk tolerance.
2. Fees: Variable annuities typically come with higher fees than fixed annuities, including management fees, administrative fees, mortality and expense risk charges, and surrender charges. These costs can significantly impact the overall return on investment, so it’s essential to understand the fees associated with a variable annuity before purchasing.
3. Complexity: Variable annuities can be complex financial products with various investment options, features, and riders. This complexity can make it challenging for investors to understand the product and make informed decisions fully.
4. Limited Liquidity: Like fixed annuities, variable annuities often come with surrender charges if the investor withdraws funds during the surrender period, which can last several years. This limited liquidity can disadvantage investors who may need access to their funds in the short term.
5. Taxation: While variable annuities offer tax-deferred growth, the gains are taxed as ordinary income when withdrawn rather than at the lower long-term capital gains rate that applies to investments outside an annuity.

How to Choose a Variable Annuity

1. Assess Your Risk Tolerance: Variable annuities are more suitable for investors with a higher risk tolerance due to their exposure to market fluctuations. Evaluate your risk tolerance and investment goals before deciding if a variable annuity is right for you.
2. Compare Investment Options: Review the available subaccounts and their historical performance when considering a variable annuity. Look for various investment options that align with your investment strategy and risk tolerance.
3. Review the Insurer’s Financial Strength: Choosing an insurance company with a solid financial rating is crucial, as it guarantees your annuity payments. Check the financial strength ratings of the insurance company with rating agencies like A.M. Best, Standard & Poor’s, and Moody’s.
4. Understand the Fees: Review the fees associated with a variable annuity, as they can impact your overall returns. It’s essential to compare the fees among different variable annuity providers.
5. Consult a Financial Advisor: Before purchasing a variable annuity, it’s a good idea to consult a financial advisor who can help you determine if this investment suits your unique financial situation and retirement goals.

Variable annuities offer the potential for higher returns through investments in the stock market, making them an attractive option for investors with a higher risk tolerance. However, they also have certain drawbacks, such as investment risk, higher fees, and limited liquidity.

Before investing in a variable annuity, assess your risk tolerance, investment goals, and financial situation to determine if this financial product aligns with your needs. Compare investment options, review the insurer’s financial strength, understand the fees, and consult with a financial advisor to make an informed decision.

By carefully considering your options and choosing the right variable annuity product, you can create a diversified investment portfolio that meets your retirement planning needs and provides financial security for you and your loved ones.