In the quest to retire rich, investors are always looking for an edge. Given the turmoil in the markets two years ago, one major consideration that retirement investors keep front and center in their investing strategy is making sure that their nest-egg principal is protected.
One way that investors protect themselves against principal loss is by using variable annuities. Although these specialty investments can indeed limit your downside in the event of a market collapse, they aren't foolproof -- and they also aren't cheap.
The state of the variable annuity
Variable annuities are insurance products, but in many ways, they closely resemble mutual funds. When you buy a variable annuity, you can choose from several investment options; your money is then invested according to whichever option you choose, just as a mutual fund would.
What makes variable annuities different from mutual funds are two things. First, variable annuities are tax-deferred, meaning that as long as you keep your money within the annuity, you don't have to pay tax on the income or capital gains that it generates. Second, the insurance aspects of variable annuities give you additional features that mutual funds lack, such as the choice to lock in guaranteed minimum income payments even if the value of the annuity's investments goes way down.
For those close to or already in retirement, that combination of features sounds perfect. But it isn't that simple. As with equity-linked structured notes that Morgan Stanley
What's in a guarantee?
In addition, the nature and extent of the guarantees have changed. Although Prudential
The changes in the variable annuity industry make sense when you step back and look at the financial challenges that the companies that sell them have faced. During the financial crisis, many insurers needed help to recover from the market meltdown and other challenges. Among annuity sellers, Hartford Financial
So with all the pros and cons of variable annuities, do they belong in your retirement portfolio? Despite the attractiveness of all the upside of stocks without the downside, the cost is simply too high for most investors to cover. Even when stocks were earning returns of roughly 10% per year, a 3.5% annual fee would have cut that to a net return of 6.5%. Putting that in context, money that would have doubled in seven years at 10% would take closer to 11 years to double at 6.5%.
More recently, with stocks earning nowhere near 10%, a big annual fee can mean the difference between a gain and a loss. And even if you pay up for guarantees, the fact is that if you're certain that you're likely to need to exercise that guarantee, you'd typically be better off just buying a Treasury bond or a bank CD. Even at low rates, something is better than nothing.
Not all annuities are bad for investors, and in certain circumstances where getting more tax deferral is paramount, low-cost variable annuities from providers like Vanguard and TIAA-CREF make sense. But for most retirement savers, it's better to get comfortable with the risk profile you select and invest accordingly.
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Fool contributor Dan Caplinger is wary of costly investments. He doesn't own shares of the companies mentioned in this article. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy ensures your satisfaction.