Are Variable Annuities a Good Investment?

Variable annuities are financial products offered by insurance companies that combine features of investment vehicles with insurance components. They are designed to provide a way to save for retirement or other long-term financial goals, with potential for growth tied to market performance while also offering certain guarantees.

Understanding Variable Annuities

A variable annuity is a contract between an individual and an insurance company. The individual makes purchase payments, either as a lump sum or a series of contributions. In return, the insurance company agrees to make periodic payments back to the individual or their beneficiaries in the future.

The structure of a variable annuity typically involves two distinct phases: the accumulation phase and the payout phase. During the accumulation phase, funds are invested and grow on a tax-deferred basis. This means investment gains are not taxed until they are withdrawn from the annuity.

The payout phase, also known as the annuitization or distribution phase, begins when the contract holder starts receiving payments. This can involve a stream of regular income payments, often for a specified period or for the remainder of the individual’s life. The decision to begin the payout phase typically aligns with retirement planning, providing a potential income stream.

A distinguishing characteristic of variable annuities is their investment component, which links the growth of the contract value to the performance of underlying investment options. Unlike fixed annuities that offer a guaranteed interest rate, the value of a variable annuity fluctuates based on how these chosen investments perform. This design allows for potential capital appreciation but also carries investment risk.

How Variable Annuities Operate

The mechanics of a variable annuity involve allocating premiums into various investment options, commonly called “subaccounts.” These subaccounts are similar to mutual funds, offering diverse portfolios that may invest in stocks, bonds, or money market instruments. The contract holder selects the subaccounts and determines how premiums are distributed, aligning with their investment objectives and risk tolerance.

The value of the annuity contract directly reflects the performance of these chosen subaccounts. If investments perform well, the contract’s value increases; poor performance leads to a decrease. The contract holder bears this investment risk, as there is no guarantee of principal return based solely on investment performance.

Throughout the accumulation phase, earnings grow on a tax-deferred basis. This tax deferral allows investment gains to compound without being reduced by annual taxes, potentially leading to greater overall growth. Contract holders can also transfer funds between different subaccounts without triggering an immediate tax event.

This tax-deferred growth mechanism is a significant feature for individuals accumulating assets for long-term goals like retirement. It enables the entire investment return to be reinvested and grow, enhancing the power of compounding. However, this tax deferral does not eliminate taxes; it merely postpones them until withdrawals are made.

Key Contractual Features

Variable annuity contracts often include or offer optional features designed to provide financial protection. A common feature is the “death benefit,” which ensures beneficiaries receive a specified minimum payout upon the contract holder’s death, even if the account value has declined. This benefit typically guarantees the greater of the account value at death or the total premiums paid into the contract, minus any prior withdrawals. Some contracts may also offer enhanced death benefits, such as a “stepped-up” benefit, which locks in the highest account value reached at certain intervals.

Beyond death benefits, variable annuities frequently offer various “living benefit riders” for an additional fee, providing guarantees during the contract holder’s lifetime. Two prominent examples are the Guaranteed Minimum Withdrawal Benefit (GMWB) and the Guaranteed Minimum Income Benefit (GMIB). A GMWB rider allows the contract holder to withdraw a set percentage of their initial investment each year, regardless of the subaccount’s performance, ensuring a steady income stream even if the market declines.

The GMIB rider guarantees the right to convert the annuity into a stream of periodic income payments at a specified minimum level after a waiting period, irrespective of the investment performance. These living benefits are contractual guarantees provided by the insurance company, backed by its claims-paying ability. While they offer valuable protection, they come at an extra cost, typically an annual percentage of the contract value.

Associated Costs and Tax Implications

Variable annuities involve several layers of fees and charges that can impact overall returns. One significant cost is the Mortality & Expense (M&E) charge, which compensates the insurance company for insurance risks, such as the death benefit and guaranteed income. M&E charges typically range from 0.20% to 1.80% annually, often falling between 1% and 1.5% of the account value.

Administrative fees are also charged to cover the costs of servicing the contract, including record-keeping and customer service. These fees can range from 0% to 0.60% annually, with a common range being 0.10% to 0.50%. Additionally, because variable annuities invest in underlying subaccounts, investors also incur subaccount expenses, similar to mutual fund expense ratios, which can vary widely from about 0.15% to over 3% annually depending on the specific investments chosen.

A common charge, particularly if funds are withdrawn early, is a surrender charge. These fees are imposed if money is taken out of the annuity before a specified period, often ranging from five to ten years after each premium payment. Surrender charges can start as high as 7% to 8% and typically decline gradually over the surrender period. Optional riders like living benefits also come with their own fees, usually an additional 0.25% to 1.5% of the contract value annually.

From a tax perspective, variable annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawn. However, when withdrawals are made from a non-qualified variable annuity, the earnings portion is taxed as ordinary income, not at capital gains rates. The Internal Revenue Service (IRS) generally applies a “Last-In, First-Out” (LIFO) accounting method to withdrawals from non-qualified annuities, meaning earnings are considered to be withdrawn first and are fully taxable until all earnings are exhausted. Withdrawals made before age 59½ may be subject to a 10% federal tax penalty on the taxable portion, in addition to ordinary income tax.

Factors for Consideration Before Investing

When evaluating a variable annuity, recognize their long-term investment horizon. These contracts are designed for retirement planning and similar extended financial goals, not for short-term liquidity needs. The presence of surrender charges for early withdrawals underscores this long-term commitment, as accessing funds before the surrender period ends can result in significant penalties.

Understanding the complexity of variable annuities is important, encompassing all fees, riders, and the range of investment options available. A thorough review of the prospectus, which details all charges and features, is recommended before making any investment decisions. The layered fee structure, including M&E charges, administrative fees, subaccount expenses, and rider costs, can collectively reduce the net returns over time.

Variable annuities are generally suitable for individuals who have maximized contributions to other tax-advantaged retirement accounts, such as 401(k)s and IRAs, and seek additional avenues for tax-deferred growth. They can be appealing for those who desire market-linked growth combined with certain insurance guarantees, such as death benefits or guaranteed income streams, to help manage longevity risk in retirement. However, the benefits of tax deferral and insurance guarantees should be carefully weighed against the higher costs typically associated with variable annuities.