Variable annuities have had a lot of articles written about them. They are advertised as insurance contracts with guarantees and the potential of stock market gains over time. They are also criticized as being overly expensive, hard to understand and inflexible. So are variable annuities good or bad?
Good or bad is not the right terminology when considering a major product offered by most insurance companies. The better terms would be appropriate or inappropriate when looking at your individual financial situation. Any insurance contract can be a benefitin a particular financial situation. You need to understand the variable annuity to determine if it might be appropriate for your long term goals.
How a Variable Annuity Works
A variable annuity contract was designed by the insurance industry to compete with the mutual fund industry. It has provisions for guarantees, deferral of taxes on earnings and death benefits, similar to fixed annuity contracts.
Where the variable annuity is unique is that prior to the time when you start receiving annuity payments, you can select how your account value will be invested. You can choose to have your money invested in a number of mutual funds. The insurance company decides which mutual funds will be offered under the contract as investments. These do not necessarily have to be in mutual funds managed by the insurance company. Many companies allow you to select funds from major mutual fund families such as T. Rowe Price, Fidelity, Scudder, etc.
It is important to understand that during this accumulation phase of the contract, you are picking your investments. It is the same as taking your assets and placing them in a combination of stocks and bonds or mutual funds. So, all investment gains or losses are applied to your particular contract.
Once you retire, you will start to receive guaranteed benefit payments for the rest of your life. However the amount of benefit payments will be dependent upon the performance of the mutual funds you selected as your investments.
The Advantage of the Variable Annuity
The primary advantage of the variable annuity should be obvious. During the accumulation phase you are permitted to determine how your money will be invested. Many contracts also come with riders that you can select to increase the level of guarantees you have under the contract. For example, one such writer will guarantee that you are fund balance will never fall below a particular amount. In essence you may gain the upside investment potential, without risking the downside loss. Such guaranteed riders are not available if you invest all of your assets in plain mutual funds with the brokerage company.
Income taxes on your earnings are deferred until you take money out of the contract. You can adjust your portfolio investments as you wish. Moving money from one mutual fund to the other as the economic climate changes gives you flexibility. This can be done without triggering a taxable event as long as the money stays within the contract.
If you put your money directly into plain mutual funds, you will be taxed on the earnings each year, unless your investments are covered under an IRA or 401k. Any portfolio adjustments will trigger a taxable event and determine if you pay ordinary tax or capital gains tax on those assets.
You have complete control over your investments during the accumulation phase. This combats one of the major objections to buying deferred fixed annuities where you are credited with a fixed rate of interest each year.
Of course, with all the advantages of a variable annuity, there must be disadvantages.
The Disadvantage of a Variable Annuity
When investing in equities, you need to understand how the stock markets works and build a diversified portfolio of quality mutual funds. Many people simply do not have the experience and knowledge necessary to do this properly. They risk putting their money in the wrong funds at exactly the wrong time in the economic cycle. Such investing will have a large impact on the level of eventual annuity payments at retirement.
Guarantees come at a cost. Annuity contracts carry much higher expenses than if you had invested in plain mutual funds. Mutual funds can be relatively cheap, especially if you use no-load funds for your investments. However, with mutual funds you do not get any guarantees attached to you portfolio.
Along with higher annual expenses, the variable annuity contract also imposes a surrender charge if you terminate the contract during the early years, usually 7 years. You need to view a variable contract as a long term contract as opposed to mutual funds where you can move in and out of them each day if you wish.
Annuities at retirement require a commitment. Once you go into pay status, you cannot merely change your mind and try to withdraw your money. So, be sure that long term annuity payments are what you want before you start to receive payouts.
Diversify Your Retirement Nest Egg
Even if you decide that a variable annuity is a good choice for your financial situation, do not put all your assets in one contract. The first rule of financial planning is to diversify your investments. No investment will perform the best all the time. Diversification allows you to smooth out the ups and downs of markets. It provides protection over the long term.
Consider putting part of your retirement nest egg in a variable contract and keep the remainder in other types of investments. On the whole, your total portfolio should be balanced throughout the accumulation years. You can then decide at retirement how much should be in a life annuity and how much should continue to be in growth investments.
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