There's an old saying that reveals a lot about the annuity business: "Annuities are not bought, they're sold." Variable annuities are a good example of this, as they often are a better deal for the people who sell them than the ones who buy them. Let's take a closer look at what they offer, and what their drawbacks are.
What's a variable annuity?
In a nutshell, a variable annuity is a contract you sign with an insurance company, where you pay the company a big lump sum -- or a series of smaller payments. In return, you receive payments from the company, immediately or in the future. It's really much more complicated than that, though, because there are lots of terms involved, and variations on those terms.
For example, if the annuity you buy is designed to only pay you for 10 years, it's likely to be less costly than one that will pay you for the rest of your life, starting at age 65. You can buy a variable annuity that will pay you for the rest of your life, or a joint one, that won't stop paying until both you and your spouse have passed away.
By design, variable annuities generally have an accumulation phase, where the money you pay grows, and a payout phase, where the company cuts you checks. The growing funds are typically invested in managed mutual funds.
When you're being pitched a variable annuity -- and that's often how they're sold, by salespeople pushing them instead of customers who are shopping for annuities -- you'll be told of their benefits, which will sound terrific. For example, consider that:
- You can receive income for the rest of your life, reducing or eliminating your chances of running out of money before you die.
- The annuity is tax deferred, so your money grows without being taxed. It's taxed when you withdraw funds.
- You can often include a "death benefit," choosing a beneficiary to receive a certain sum should you die before you receive all guaranteed payouts, or if your account's balance is above a certain level.
Those are solid benefits, but you should know that you can also get the same or similar benefits from less problematic annuities, such as fixed and/or immediate annuities. (While variable annuity payouts rely on the performance of an underlying security or the stock market, fixed annuities offer specified payouts, with less mystery. Immediate annuities are ones that begin paying immediately, instead of at a later date.)
Some variable annuities will charge you no up-front fee upon purchase, and this will be a touted feature. Don't think of that as just a gift, though. The annuity will be structured so that whatever the issuer loses by not charging you a sales fee will be made up for in other charges. Remember, too, that there are gobs of no-load mutual funds that charge no sales fee, and buying stocks or bonds in an investment account typically costs no more than a modest commission fee, at most.
Another advantage of the variable annuity is that, because you get to choose how the money in your account is invested -- conservatively, aggressively, or somewhere in between -- you can end up with exceptionally good results -- if the investments perform as you hope. Of course, because most of us are not expert stock, bond, or fund pickers, we can end up with sub-par results, too, receiving less from the annuity than we'd hoped. This advantage is, therefore, also potentially a disadvantage.
Here's why variable annuities are problematic:
- They often charge steep fees and costs. Even seemingly small fees can eat into your return, making a big difference in the long run. A variable annuity is likely to charge you fees for mortality and expense risk, along with general administrative fees. In addition to that, the securities you elect to invest your annuity money in, such as mutual funds, will charge fees of their own. Taken together, these fees add up and reduce the appeal of a variable annuity over other alternatives. Annuity expert Stan Haithcock has found the average total deferred variable annuity fee to be 3%, which can take a big bite out of your overall returns.
- Variable annuities charge "surrender" fees, too, which can be substantial. If you want to withdraw money within the first few years, you'll be socked with a surrender fee of, typically, between 5% and 7%. It will be gradually reduced over about five to seven years. Along with that, there's also a 10% tax penalty that applies to withdrawals made before age 59-1/2. (This penalty applies to other retirement accounts, too, such as 401(k)s charge.)
Another danger to be aware of is one that applies to all annuities: If the insurance company behind the annuity you buy goes under, you're not likely to receive all the money you expected. Thus, it's important to buy from high-quality, highly rated insurers.
Think carefully and weigh your options
Variable annuities present enough risk to investors that the Securities and Exchange Commission (SEC) offers explicit warnings, noting: "Other investment vehicles, such as IRAs and employer-sponsored 401(k) plans, also may provide you with tax-deferred growth and other tax advantages. For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity."
Still, variable annuities, or other annuities, can make sense for some people. If you're interested in buying one or more, look into buying directly from top-rated insurers instead of from salespeople who will receive hefty commissions from selling to you. Read any investment's prospectus, and make sure you know about all fees and all the terms of the product.