Pros and Cons of Variable Annuities
Variable annuities were a welcome addition to the insurance product arsenal back in the 1970’s. With the advent of the 401k plan, and IRA’s, the average worker began learning about investment planning for retirement and tracking their investments on a regular basis. Also, with inflation spiking in the 70’s, retirees began clamoring for more investment related products from the insurance companies. The insurance companies answered this call by designing the variable annuity product. The variable annuity allowed contract owners to receive some of the guarantees offered in fixed annuity contracts, while getting exposure to stock market investments. Advertising was intense and many people moved their retirement nest eggs into variable annuity contracts.
What is a Variable Annuity?
A variable annuity is a contract with an insurance company, in which you make a lump-sum payment or series of payments. The insurer guarantees to make periodic payments to you beginning immediately or at some future date. You can choose to have your account balance invested in a range of investment options, which are normally common stock mutual funds. The value of your variable annuity account will go up or down depending on the investment performance of the options you have chosen.
The variable annuity contract also has a number of provisions or available riders that are popular in fixed annuity contracts. Some of these provisions are guaranteed periodic payments under different payout options offered when you retire, tax deferred treatment of investment earnings, built in death benefits.
The First Variable Annuity Stumbling Block
As stated before, variable annuities were heavily promoted in the 1970’s and sold as the most modern investment for retirees. Unfortunately, several years after the first rush of variable annuity products hit the market, the stock market began dropping and the economy went into recession. Nothing unusual in the investment world, but this event appeared to take all variable annuity owners by surprise.
There was much grumbling as contract balances began to decline, especially if the variable annuities were in company sponsored pension plans. The variable annuity contracts performed exactly as they were designed to perform. For several reasons, the contract owners never thought the contract values would drop. These reasons had to do with how the insurance agents described and sold the contracts, the average worker did not truly understand how these contracts worked, and a blind desire to get more growth in their retirement assets.
Once the fervor of the 1970’s settled down, people viewed variable annuity contracts as they should be viewed. Mainly, these contracts are very good for some people and not appropriate for other people. The contracts have definite pros and cons, good in some financial situations and not so good in others, touted by some and hated by others.
Pros of a Variable Annuity
The primary advantage of variable annuities is your ability to invest in equities. Mutual funds containing common stocks have the potential to yield a higher return than CDs or fixed annuities over the long term. These funds can combat the main issue facing retirees, which is inflation.
Variable annuities permit tax deferred asset growth. Investment gains will accumulate tax-deferred until distributions begin.
Variable annuities permit diversification of investments. You can choose from a multiple of different asset classes, each with a different degree of risk. You can be conservative or aggressive with your investments.
A variable annuity is flexible from a tax viewpoint. You can switch funds in your investment portfolio without incurring any taxes or tax penalties.
You have complete investment control over your account. You can direct your own money into any of the investment options that wish. Once you retire, you will have periodic income for life guaranteed by the insurance company.
Cons of a Variable Annuity
The primary advantage of a variable annuity is also its primary disadvantage. Investing in equity or stock investments can cause your retirement nest egg to severely drop. Workers who may not understand stock investing may put their assets into funds which may not be appropriate based on their long term objectives.
Variable annuities are not cheap. There may be administrative expenses, mortality expenses, agent commissions, and investment loads applied to each fund option.
When the annuity stream starts, you are committed. You cannot later request to have all your money back because you changed your mind.
Your guarantee of a lifetime annuity is only as good as the company making the guarantee. Should the insurance company go under, you stand to lose some or all of your income. It is important to choose a strong, highly-rated company.
Be Sure Before You Buy a Variable Annuity
These products are well suited to certain financial planning situations. For example, a high net worth individual may have reached the maximum he can contribute to his tax deferred retirement plans. Yet he still needs another vehicle to invest in equity while deferring taxes. The variable annuity might be his answer.
On the other hand, these products are not suited for a lot of people. For example, a couple near retirement who only have a small nest egg and their Social Security check to meet monthly expenses probably should not be considering a variable annuity. There would just be too much investment risk under the contract.
If you are considering a variable annuity, make sure you know each of the provisions, how the account will perform during good economic times and bad, and what the worst case scenarios are.