Is a Variable Annuity a Good Investment?

A variable annuity is a contract between an individual and an insurance company, representing a retirement savings product. It combines investment features with certain insurance guarantees. This financial product is designed to grow funds on a tax-deferred basis, offering a pathway to potential market growth. Many individuals explore variable annuities as a means to secure future income, prompting a closer look at their structure and implications.

Understanding Variable Annuities

A variable annuity functions as both an investment vehicle and an insurance contract, offering a unique blend of market participation and financial protection. An individual pays a lump sum or a series of payments to an insurance company, which then invests these funds according to the contract owner’s choices. This arrangement allows the money to potentially grow over time.

The product operates in two distinct phases. The first is the accumulation phase, where the invested funds grow on a tax-deferred basis, meaning earnings are not taxed until they are withdrawn. This allows for compounding growth without immediate tax implications. The second is the annuitization phase, where the accumulated value can be converted into a stream of periodic payments. This income stream can be structured to last for a specified period or for the remainder of the individual’s life.

During the accumulation phase, the value of the annuity fluctuates based on the performance of the chosen underlying investments. This provides the potential for increased returns, but also carries the risk of investment losses. The ability to eventually convert the accumulated value into a guaranteed income stream offers a level of financial security, protecting against the risk of outliving one’s savings.

Key Components and Characteristics

Variable annuities are comprised of distinct parts that influence their behavior and value. Understanding these elements is important for evaluating the product.

Sub-accounts

Sub-accounts form the investment core of a variable annuity. These are professionally managed investment options, similar in nature to mutual funds, that invest in various asset classes such as stocks, bonds, or money market instruments. The contract holder selects how their contributions are allocated among these sub-accounts, and the value of the annuity directly reflects their investment performance. While sub-accounts offer diversification and growth potential, their values fluctuate with market conditions, influencing the overall cash value of the annuity.

Death Benefits

Death benefits are an insurance feature of variable annuities, providing a guaranteed payout to designated beneficiaries upon the contract holder’s death. A common type is the return of premium death benefit, which ensures beneficiaries receive at least the amount initially invested, minus any prior withdrawals, even if the account value has declined due to market performance. Other variations include stepped-up death benefits, which may lock in the contract’s value at certain anniversaries or highest-ever values, providing a larger payout to heirs. These enhanced death benefit options come with additional fees.

Living Benefits

Living benefits are optional features, often referred to as riders, that can be added to a variable annuity contract for an additional cost. These riders are designed to provide various guarantees during the contract holder’s lifetime. One such benefit is a Guaranteed Minimum Accumulation Benefit (GMAB), which ensures the account value will reach a certain minimum amount by a specified date.

Another is a Guaranteed Minimum Withdrawal Benefit (GMWB), allowing the contract holder to withdraw a predetermined percentage of their initial investment each year for life, even if the account balance falls to zero. A Guaranteed Minimum Income Benefit (GMIB) assures a minimum future income stream, regardless of how the underlying investments perform.

Costs and Taxation

Variable annuities involve several types of fees and specific tax rules that impact their overall financial outcome. Understanding these charges and tax implications is important for assessing the product’s value. These financial aspects can significantly influence the net returns an investor receives.

Fees

Various fees are associated with variable annuities, which can collectively diminish investment returns. Mortality and Expense (M&E) charges compensate the insurance company for the insurance risks assumed, including death benefits and guaranteed income features, often ranging up to 2% of the contract value annually. Administrative fees cover the costs of maintaining the annuity contract, while underlying fund expenses are charged by the sub-accounts for investment management, similar to mutual fund expense ratios, potentially ranging from 0.15% to 3.26% annually.

Optional living and death benefit riders also incur additional fees for the guarantees they provide. The cumulative effect of these various fees can be substantial, with total annual charges often ranging from 2% to 3% or even higher, reducing the net growth of the investment.

Surrender Charges

A surrender charge may be imposed if funds are withdrawn from the annuity within a specified period, typically ranging from five to ten years after each purchase payment. This charge often starts at a higher percentage, such as 7%, and gradually declines over the surrender period. Most variable annuities include a “free look” period, usually 10 days or more, during which the contract can be canceled without incurring a surrender charge, though the refunded amount may be adjusted for market performance.

Taxation

Variable annuities offer tax-deferred growth, meaning that investment earnings accumulate without being subject to current federal income tax until withdrawals are made. This allows for greater compounding over time compared to taxable investment accounts. However, when withdrawals occur, earnings are taxed as ordinary income, not at potentially lower capital gains rates. For non-qualified annuities, which are purchased with after-tax dollars, withdrawals are subject to the Last-In, First-Out (LIFO) rule, meaning earnings are considered to be withdrawn first and are fully taxable until all earnings have been depleted.

Withdrawals made before age 59½ may be subject to an additional 10% federal income tax penalty on the taxable portion, as outlined in Internal Revenue Code Section 72(q). Exceptions to this penalty exist for specific circumstances, such as death, disability, or systematic withdrawals in substantially equal periodic payments. When the annuity is annuitized, meaning converted into a stream of regular income payments, a portion of each payment may be considered a tax-free return of principal if the annuity was purchased with after-tax funds. This non-taxable portion is determined by an exclusion ratio based on the initial investment and expected payout period, with the remaining portion of each payment taxed as ordinary income. After the initial investment is fully returned, all subsequent payments become fully taxable.

Evaluating Investment Performance

The investment performance of a variable annuity is directly linked to the performance of its underlying sub-accounts. These sub-accounts are exposed to market fluctuations, meaning their value, and consequently the annuity’s cash value, can increase or decrease based on market conditions. This direct market exposure distinguishes variable annuities from fixed annuities, which offer a guaranteed rate of return.

While variable annuities offer the potential for growth through market participation, the various fees associated with them significantly reduce net returns. The combined effect of M&E charges, administrative fees, sub-account expenses, and rider costs can create a substantial drag on performance. For example, annual fees ranging from 2% to 3% or more directly reduce the amount of investment growth that accrues to the contract holder. This continuous reduction means that even if the underlying sub-accounts perform well, a significant portion of those gains can be absorbed by fees.

When comparing a variable annuity to a direct investment in a similar portfolio of mutual funds, the additional layers of fees inherent in the annuity structure typically result in lower net returns. While both involve market risk, the insurance features and guarantees of a variable annuity come at a cost that is not present in direct investment products. This difference in cost structure means that the actual investment growth realized by the annuity holder may be considerably less than what the gross returns of the underlying investments might suggest. The long-term impact of these fees on compounding growth can be substantial, making it important to consider them in any performance evaluation.

Determining Personal Suitability

Deciding whether a variable annuity is a suitable investment involves evaluating it against individual financial circumstances and objectives. The product’s features, costs, and potential for performance must align with a person’s specific needs. This assessment requires a thorough understanding of one’s financial landscape.

Long-term financial goals, particularly retirement planning, are a primary consideration for variable annuities, as they are designed for extended holding periods. Individuals should examine their existing investment portfolio and other retirement savings vehicles, such as 401(k)s and IRAs, which often provide tax deferral with potentially lower fee structures. Maxing out contributions to these traditional retirement accounts before considering a variable annuity is a common strategy.

An individual’s risk tolerance also plays an important role in this determination. Variable annuities expose investors to market risk through their underlying sub-accounts, meaning values can fluctuate and losses are possible. The desire for guaranteed income streams or death benefits must be weighed against the potential for higher growth and the costs associated with these guarantees. The impact of fees on long-term returns is a significant factor, as the cumulative effect of annual charges can substantially erode investment gains over decades.

The liquidity aspect of variable annuities also warrants careful consideration. These products are generally illiquid, and early withdrawals can trigger surrender charges, which can be a significant percentage of the amount withdrawn. This lack of immediate access to funds makes variable annuities less suitable for short-term financial needs. Ultimately, a variable annuity may be appropriate for individuals seeking tax-deferred growth and specific insurance guarantees for their retirement income, especially those who have already maximized contributions to other tax-advantaged accounts and are comfortable with the associated costs and long-term commitment.