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Variable Annuities Can Be a Prescription for Trouble

By Selena Maranjian - Dec 6, 2015 at 7:20AM

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Variable annuities have some appealing features, buy significant drawbacks, too. Learn more about them and consider alternatives, as well.


Photo: Peter, Flickr

Whether you think annuities are good or bad, you're wrong. Some, such as immediate fixed annuities, are generally good, and some, such as indexed annuities, are generally ill-advised. Variable annuities can make sense for some folks in some situations, but you can often find better income solutions and better annuities for yourself. Let's take a closer look.

An introduction to the variable annuity
A variable annuity essentially is a contract you sign with an insurance company. You agree to fork over a big lump sum (or a series of smaller payments), and the insurer agrees to send you regular payments (or a lump sum) in the future. Don't assume it's a simple arrangement, though, because there are lots of details and terms to consider and decisions to make.

The cost of an annuity will vary, for example, based on how long you expect to receive payments. One set to pay you for the rest of your life may cost more than one that just lasts 15 years. If the annuity promises payments to your spouse if you die, that can add to its cost (or shrink your monthly checks).

Variable annuities generally have an accumulation phase, where the money you paid grows, and a payout phase, where the company cuts you checks. The money that you pay in is often invested in mutual funds, with the expectation that it will grow over time.

Why consider a variable annuity?
Many people considering variable annuities are doing so because some salesperson has urged them to -- perhaps without disclosing the commission or reward he or she will get for selling you one. Variable annuities do have some appealing features, such as:

  • Tax-deferral. Your money in one grows without being taxed. It's taxed later, when you withdraw funds.

  • Income for the rest of your life. That sure sounds hard to beat, as it can help you not run out of money in retirement.

  • A "death benefit." Some variable annuities will let you choose 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.

Another apparent upside of variable annuities is that they give you more control than fixed annuities. You get to choose how the money in your account is invested -- conservatively or aggressively or somewhere in between -- so if your choices turn out well, you can end up with bigger checks come payment time. Of course, there are no guarantees, and you're also exposed to the risk of investments underperforming, leaving you with less than you'd hoped or planned for.

Image: Got Credit.

Why avoid a variable annuity?
So why do many people put down variable annuities? Well, lots of reasons:

  • They are often very expensive, with steep fees and costs. A variable annuity will probably charge you fees for mortality and expense risk, along with general administrative fees. In addition to that, the securities you invest your annuity money in, such as mutual funds, will charge fees of their own. These fees add up, making many alternatives to variable annuities look better in comparison. Annuity expert Stan Haithcock has found  the average total deferred variable annuity fee to be 3%. That will reduce your investment's performance significantly. A $50,000 investment will grow to $107,946 at an annual rate of 8% over a decade, but will only reach $81,444 growing at 5% -- fully $26,500 less!

  • Variable annuities often charge "surrender" fees, also. If you want to withdraw some or all of your invested assets 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.) If you face a 6% surrender fee on a $20,000 withdrawal, that's $1,200 in cash going up in smoke. Plus, potentially, a $2,000 tax penalty. Ouch.

Finally, here's a caution that applies to all annuities: If the insurance company you buy your annuity from goes out of business, your contract probably won't be fully honored. So it's critical to stick with highly rated, high-quality insurers.

You can feel like a cat stuck in a tree after buying a variable annuity. Photo: Pixabay

Consider alternatives
Variable annuities present enough risk to investors that the Securities and Exchange Commission warns investors about them, 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."

While advantages of variable annuities such as income for the rest of your life, tax-deferral, and death benefits may be appealing, they're not exclusive to variable annuities. You can get the same or similar benefits from less problematic annuities, such as fixed and/or immediate ones. (While variable annuity payouts relay 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.)

If you're drawn to a variable annuity that will  charge you no up-front fee upon purchase, don't be gullible. 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.

Still, variable annuities, or other annuities, can make sense for some people. If you're interested in buying one, consider doing so directly from top-rated insurers instead of from salespeople who are chasing commissions or rewards. Read any investment's prospectus, and make sure you know about all fees and all the terms of the product. Consider consulting a financial advisor (ideally a fee-only one), too, to help you zero in on what's best for you.

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