The variable annuity is one of the least-understood investment vehicles available to ordinary investors. As a combination of an investment with an insurance product, variable annuities are at the center of a sharp debate, with proponents pointing to their unique characteristics while critics emphasize their weaknesses. To cut through the arguments, let's take a closer look at what a variable annuity is and how you can decide whether it's the right place for you to put your money.
How a variable annuity works
Variable annuities are contracts between the investor and an insurance company. In exchange for the money you spend buying the annuity, the insurance company promises to pay you or the person you designate certain lifetime benefits. Under some circumstances, the insurance company will pay a death benefit to the person you name as beneficiary after you die.
What makes an annuity variable is what happens to the money once you enter into the contract. Insurance companies offer a wide variety of investment vehicles for variable annuities, giving the ability to participate in mutual-fund-like pools of investments in stocks, bonds, or other types of assets. In general, as long as you haven't elected to start receiving payments from your variable annuity yet, you can switch between different investment pools at will as long as they're offered by the same insurance company. So if you initially chose to invest solely in stocks but decide at a later point that you'd prefer a lower-risk investment, then you can switch to a pool that's more balanced between stocks and other investments.
The benefits of variable annuities
Most of the benefits that you get from a variable annuity come long after you buy it. But investors get one benefit from using variable annuities almost immediately: Any income the annuity earns is tax-deferred, making annuities a popular retirement vehicle.
If you decide to start receiving payments under the annuity, you can elect to collect periodic payments for the rest of your life, or other options are typically available. You can choose to get payments as long as either you or your spouse are living, and you can specify a certain minimum length of time to get payments even if you die before they're all paid out. The insurance company will also often offer various guaranteed benefits, such as a minimum level of income or available withdrawals from the annuity based on market fluctuations during the period you owned the annuity.
If you die before you start getting payments, then your beneficiary will get a death benefit. That benefit is often equal to the current value of the annuity, but in some cases, insurance companies will guarantee that you'll get at least the amount you paid in premiums, even if the investment you chose lost value.
The costs of variable annuities
Where the debate begins, though, is in the cost of annuities and their various features. Because a variable annuity is an insurance contract, the insurer charges what are known as mortality and expense risk fees to cover the insurance-cost elements of the annuity. Administrative fees apply, and you'll also pay the investing costs of managing the underlying investment pool. In addition, many of the optional features that insurers offer, such as the guaranteed minimum income benefit or larger death benefits, come with additional fees you pay annually.
Annuities also typically come with what are known as surrender charges. These fees apply if you take money out of a variable annuity within a period of years after you buy it. Surrender periods typically run from six to 10 years, making it necessary for you to understand that variable annuities are a long-term investment that you shouldn't enter into lightly.
Critics argue that variable annuities are more expensive than they're worth, with alternatives like retirement accounts and mutual funds offering some of the same tax benefits at a lower cost. Yet proponents of annuities note that it's hard for investors to find other investments that offer the same ability to protect themselves from investment and longevity risk, and so reasonable investors could choose to pay added charges for the unique features annuities have.
Variable annuities can be tough to understand, but they have an interesting set of characteristics that can be useful to many investors. There's no one right or wrong answer about variable annuities and their suitability for investors in general. Whether a variable annuity is worth the added cost depends on your particular situation, but having objective information should help you make a smarter decision than simply relying on a sales pitch.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.