Are Variable Annuities a Good Investment?

Variable annuities are financial products that combine investment features with insurance components, designed to offer potential growth alongside certain guarantees. They represent a contract between an individual and an insurance company, where the insurer promises to provide future income payments in exchange for premiums. Understanding the various characteristics of variable annuities can help individuals determine if these products align with their long-term financial objectives.

Understanding Variable Annuity Structure

A variable annuity is a contractual agreement between an individual, known as the annuitant, and an insurance company. This contract operates in two phases: the accumulation phase and the payout phase. During the accumulation phase, the annuitant contributes funds, either as a lump sum or through periodic payments, which are then invested.

These invested funds are held within “separate accounts,” legally distinct from the insurance company’s general assets. This separation protects the funds from creditor claims. Contributions are allocated among “subaccounts,” which function much like mutual funds. These subaccounts offer diverse investment options, including portfolios focused on stocks, bonds, or money market instruments, allowing for potential investment growth.

Once accumulation concludes, the contract transitions into the payout phase, also known as annuitization. The accumulated value is converted into a stream of regular income payments. Payment duration varies, from a specified period to the annuitant’s life or joint lives. Payment value fluctuates with subaccount performance, though some payout options may offer guaranteed income.

Investment and Benefit Features

Variable annuities allow participation in market growth through subaccount selection. Annuitants choose from investment options like large-cap stocks, international equities, or bond types, each with varying risk and potential return. The annuity’s value directly reflects subaccount performance, fluctuating with market changes.

To mitigate investment risks, variable annuities often include optional “riders” for an extra cost. A common death benefit guarantees a minimum payout to beneficiaries upon the annuitant’s death, regardless of investment performance. This ensures beneficiaries receive at least the initial investment, or a stepped-up value based on the highest account value achieved on a contract anniversary.

Living benefits provide guarantees while the annuitant is alive. A Guaranteed Minimum Accumulation Benefit (GMAB) ensures the contract’s account value reaches a specified minimum by a certain date, even if market performance is poor. A Guaranteed Minimum Withdrawal Benefit (GMWB) allows annual withdrawals of a predetermined percentage (typically 5% to 7% of a benefit base) for life, even if the account value falls to zero due to market downturns or withdrawals.

The Guaranteed Minimum Income Benefit (GMIB) guarantees minimum future income if the annuitant annuitizes later. This benefit establishes a “benefit base” that grows at a guaranteed rate, independent of subaccount performance, determining the minimum income stream during payout. These riders protect against market volatility and longevity risk, but incur additional fees.

Costs and Tax Implications

Variable annuities have multiple fees that reduce investment returns. The Mortality and Expense (M&E) fee covers insurance guarantees (death and living benefits), typically 0.50% to 1.50% annually of the account value. Administrative fees cover contract maintenance, either a flat annual charge ($30-$50) or a small percentage (0.10%-0.30%).

Subaccounts incur investment management fees, similar to mutual fund expense ratios, generally 0.25% to 2.00% annually depending on the subaccount’s strategy. Optional riders (guaranteed living or death benefits) add 0.25% to 1.50% annually per benefit.

A notable cost is the surrender charge, a penalty for early withdrawals within a specified period (typically five to ten years). These charges usually decline over time, for example, starting at 7% in the first year and decreasing by 1% annually until zero. This discourages early withdrawals.

Variable annuities offer tax-deferred growth; earnings are not taxed until withdrawn. This allows faster growth compared to taxable accounts. However, withdrawals are taxed as ordinary income, not capital gains. The IRS applies a “last in, first out” (LIFO) rule, meaning earnings are considered withdrawn first for tax purposes.

Withdrawals before age 59½ are generally subject to an additional 10% federal income tax penalty, unless an exception applies. Upon the annuitant’s death, beneficiaries receiving a lump-sum death benefit pay ordinary income tax on any earnings. If annuitized, payments are taxed over time. Unlike other inherited assets, variable annuities do not receive a stepped-up basis at death, meaning embedded gains remain taxable to the beneficiary.

Factors for Consideration

When evaluating a variable annuity, individuals should carefully consider its liquidity. Variable annuities are generally illiquid investments, primarily due to surrender charges that penalize early withdrawals. The typical surrender period, often lasting five to ten years, means that accessing funds prematurely can result in a significant reduction of the invested capital. This illiquidity makes variable annuities unsuitable for individuals who anticipate needing access to their funds in the short or medium term.

The inherent complexity of variable annuities is another significant factor to consider. These products often involve multiple layers of fees, a diverse array of investment subaccounts, and various optional riders, each with its own terms and costs. Understanding how all these components interact and impact the overall return and guarantees can be challenging, requiring a thorough review of the contract details. This complexity can make it difficult for individuals to compare different variable annuity products or fully grasp their implications.

Variable annuities can align with specific financial goals, particularly for long-term planning horizons. They are often considered by individuals focused on retirement income planning, especially those seeking a guaranteed income stream in their later years, which certain living benefits can provide. The death benefit feature also makes them relevant for legacy planning, ensuring a minimum payout to heirs. For individuals who have already maximized contributions to other tax-advantaged retirement accounts, such as 401(k)s and IRAs, a variable annuity can offer an additional avenue for tax-deferred growth.

These products are generally long-term investment vehicles, and their benefits are most realized when held for an extended period, allowing for potential tax-deferred growth and the utilization of income guarantees. They may be less suitable for those with shorter investment horizons or those who prioritize immediate access to their capital. Understanding these factors helps individuals determine if a variable annuity fits their personal financial situation and objectives.