Annuities are an investment category some investors turn to as an alternative to the uncertainty of the stock market. What could be bad about an investment that pays you a guaranteed future income? Many financial planners caution investors against variable annuities.
To understand what a variable annuity is, let’s start with a plain vanilla, old-time annuity. Annuities are an insurance product designed to guard against ending up broke in retirement. Straight annuities pay you a fixed sum starting at an agreed upon point in the future. As human longevity has increased, annuities have gained in popularity as a way to invest that guarantees you won’t outlive your savings. Even if you live to 120, that annuity will keep on paying out, which is this vehicle’s main advantage.
The other benefit: As your annuity grows over the years, you won’t owe immediate tax on the gain. You’ll only pay taxes as you withdraw the money later, presumably paying lower taxes on your smaller, retirement-era income. (If you invest in annuities through another tax-deferred retirement vehicle, such as a 401(k) plan or an individual retirement account, there’s no additional tax advantage.)
Annuities got spiced up in recent years with a lot of different variants. One of the most common vehicles, variable annuities, may sound even better on the surface than an old-time annuity. A variable annuity allows you choices in how your annuity money is invested.
Many financial planners caution investors against variable annuities, citing the following factors:
- High fees: In general, the fees charged for annuities make them a good option only if you’re already investing the maximum allowed annually in your standard retirement accounts and are looking for additional investment vehicles.
- They’re complicated: Often even the agent or financial planner selling them doesn’t fully understand or spell out all their ramifications, so you may be getting into a product about which you’re not fully informed.
- Steep penalties: Should you need to withdraw your money early, you will erase the tax benefits you enjoyed and more.
- Boggling variety: There are many flavors of variable annuities, making it hard for lay consumers to know if they’re getting the right one.
Though you are guaranteed a perpetual payout later on, the size of that payout may vary depending on how your investments fare. You can also designate payouts for the life of your spouse or other relative instead of yourself.
Variable annuities also come with a “death benefit”; that is, if you die before any payments have started, whomever you’ve named as beneficiary will receive a payment, usually at least the size of your initial investment.
There are two phases to a variable annuity: accumulation and payout. In the accumulation phase, you make “purchase payments,” which you’ll invest in various options: bonds, international stocks, U.S. small-cap stocks, and so on. Depending on how markets and interest rates trend, your investments may grow or decrease.
In the payout phase, you begin to receive payments. Most people elect to receive payments monthly, but you can also receive them as a single lump sum in some cases. Your contract will specify the term of payments: lifelong, or perhaps for 20 years. You may elect payments that are fixed or that vary as your investments grow or shrink.
The Securities and Exchange Commission, which regulates variable annuities, recommends reading the prospectus carefully for any variable annuity you consider buying. (Read its guide to shopping for VAs.) In short, learn all you can about variable annuities and ask a lot of questions before buying.
Business reporter Carol Tice contributes to several national and regional business publications.