What Are Variable Annuities and Do They Make Sense?

Variable annuities are long-term investment vehicles designed for retirement purposes. Variable annuities became very popular after the federal government reduced the tax benefits for people with higher income in the 1980s. In fact, variable annuities jumped from $9 billion in sales in 1986 to $98 billion in 1998. Are variable annuities being oversold? First let's look at what variable annuities are and how they work.

Variable annuities are tax-deferred investment vehicles that come with a minimal insurance contract so they can qualify for their tax-deferred status. The insurance is not much more than a thin wrapper to secure that favorable tax treatment. It only covers your contributions, not any of your investment gain.

Variable annuities can be immediate or deferred. Once you reach 59 ½ you can begin withdrawing the funds without penalty. Prior to that time withdrawals are subject to tax and a 10% penalty. When you withdraw the funds, they are taxed at ordinary income tax rates, which can be as high as 39.6%. Many financial advisors think you have to hold a variable annuity for 15 to 20 years before it is more tax efficient than a mutual fund, whose capital gains are taxed at the more favorable long term rate of 20%.

Another major disadvantage of variable annuities are the fees you will need to pay. The average annual expenses on variable annuities total 2.08% according to Morningstar, which includes fund expenses and insurance expenses. The average mutual fund charges 1.34%. Many variable annuities also have loads on their subaccounts, surrender charges for selling early (usually prior to a required holding period, say seven years) and annual contract charges of about $25. Variable annuities also don't make sense as an estate planning vehicle. If you die with money remaining in your variable annuity, your beneficiary will inherit all the taxes you have deferred. If the money were in a mutual fund, the basis is stepped-up at death.

Before considering a variable annuity, you should definitely have maxed out on all other retirement investment options, including an employer sponsored 401(k), 403(b), Simple IRA, SEP-IRA, or Keogh and any other IRA options available to you. If you have no other good options and want to buy a variable annuity, be certain to find one with low fees. Mutual fund companies such as Vanguard, Fidelity, T.Rowe Price, and Scudder have some of the lowest fees. Also be certain that there is a wide range of investment options in your investment subaccount.

What is the Difference between Fixed Annuities and Variable Annuities?

Fixed annuities pay the same amount each month, while variable annuities pay an amount that depends on the investment performance of the investments held by the particular annuity. Thus, fixed annuities are like defined benefit pension plans, such as Social Security, while variable annuities are like defined contribution pension plans, such as a 401k.

Fixed Annuity Considerations

A fixed annuity offers tax-deferred growth. The earnings on your contract will not be taxed until they are withdrawn. That means the capital that would ordinarily go to the tax collector will instead accumulate interest for you.

Over the life of your fixed annuity contract, that tax deferral can make a significant difference in your earnings.

A fixed annuity offers a fixed rate of return. You know the rate of return at the beginning of each period - and that security can be very comforting.

And finally, a fixed annuity offers a death benefit. If the annuitant dies before payout, his or her beneficiaries will receive all the purchase payments plus any accumulated earnings.

Variable Annuity Considerations

A variable annuity offers many of the same benefits as a fixed annuity, including tax-deferred growth and a death benefit.

Unlike a fixed annuity, however, you control where the value in your contract will be invested. Within the limits of the investment divisions, you can be as aggressive or as conservative as you'd like.

This gives a variable annuity the potential for higher returns than a fixed annuity.

But remember: this potential for higher returns requires you to assume a greater risk of loss.

Which is Better - a Fixed Annuity or a Variable Annuity?

As always in finance, the answer is that it depends on the purchaser. The key decision variable is whether the annuitant needs or wants a fixed periodic payment. As a general rule, anyone under the age of 60, or anyone needing the tax deferral, should opt for a variable annuity. Generally speaking, only those who really need the fixed income should choose a fixed annuity. There is, however, an interesting investment strategy using a fixed annuity paid for with non-tax deductible funds in which the payments are invested in mutual funds. This is the subject of another article.

Making the Choice Between Fixed Annuities and Variable Annuities

The type of annuity contract you choose, then, depends on what function you'd like it to fill in your savings and investment portfolios.

Both fixed and variable annuities offer tax-deferred growth and a death benefit. But where a fixed annuity offers a fixed rate of return, a variable annuity offers some flexibility.

If you need an addition to your portfolio that offers stable, tax-deferred growth with high security, a fixed annuity could be just what you're looking for.

On the other hand, if you're looking for a tax-deferred investment that will let you take a more active role, a variable annuity could be right for you.

Whichever you choose, an annuity contract can be an attractive addition to your investment and savings portfolio.

Withdrawals made from an annuity prior to age 59 ½ may be subject to a 10 percent penalty. Generally, surrender charges apply if withdrawals are made in the early years of the policy. An annuity's benefits are contingent upon the claims-paying ability of the issuing insurance company. Variable annuity subaccounts fluctuate with changes in market conditions and, when surrendered, your principal may be worth more or less than the original amount invested.

Combining Variable Annuities with Other Annuities

One way to enhance your own financial future is by building a portfolio that may provide protection against loss of principal while taking advantage of the opportunity for potential stock market returns. Using a combination of variable annuities and fixed annuities together may help you build such a portfolio.

In a hypothetical example, half of a $500,000 sum was placed in an immediate fixed annuity with a guaranteed 5 percent annual interest rate. The remainder was placed in a variable annuity that has strong growth potential. The fixed annuity would provide a $24,000 annual pre-tax income for 15 years, which could be used to augment income from Social Security and other retirement plans. Remember, the guarantees of fixed annuity contracts are contingent on the claims-paying ability of the issuing insurance company.

By the time the fixed annuity is exhausted, the variable annuity account could potentially have grown to almost $600,000, assuming a hypothetical 6 percent average annual return. At this point, the account owner can consider purchasing another fixed annuity and possibly starting the process again. Remember, variable annuities generally contain mortality and expense charges, account fees, investment management fees, and administrative fees. They are sold by prospectus only. Be sure to read the prospectus carefully before deciding whether to invest.

Having enough money to last throughout retirement is a common concern. Earning a guaranteed income while pursuing growth is one way to help ensure that your retirement assets last as long as you will need them.

For Whom Do Variable Annuities Make the Most Sense?

If you are retired and fear you may outlive your capital, if you are a high income individual who does not qualify for a Roth and has maxed out on all other retirement options, and if you could be a potential target for a lawsuit, a variable annuity can work for you. This also may be an attractive option if you are a provider of personal services who could be liable in a malpractice suit, because in most states assets in life insurance policies and annuities are credit protected.