FINANCIAL TOOL
Variable Annuity
Variable annuities can be a touchy subject.
Some people love them. Others hate them.
Let’s start with the elephant in the room: they’re expensive!
Why? Because they offer a safety net in a unique way. And therein lies the benefit.
Here’s how they work:
- Funding – An investor typically places a lump sum into an annuity.
- Investment Options – The investor chooses among available funds to invest in the stock market, with their account balance rising and falling with those investments.
- Annuitization – At some point in the future, the investor can annuitize, giving up access to the lump sum in exchange for a guaranteed payout (a specific percentage) for the rest of their life.
- Tradeoff – The downside of annuitizing:
- They lose both the asset and the income stream upon death, unless protected by contract clauses like period-certain, joint-life, or refund options (all common features).
- The investor gives up access to the asset’s lump sum value.
- Living Benefit Rider – Many annuities offer this (for an extra fee), which:
Allows the investor to withdraw a guaranteed maximum annual income for life while maintaining access to the underlying account.
- Keeps the option to close out the annuity and take the remaining lump sum if desired.
- Continues guaranteed income even if the account balance hits zero (depending on the contract).
- Provides a death benefit to beneficiaries if the investor dies before the account is depleted.
- Tax Deferral – Annuities grow tax-deferred; taxes aren’t due until withdrawals are made, and growth is taxed as ordinary income.
- Tax-Free Trades – Investors can trade within the annuity without creating taxable events. The trade-off is potentially higher ordinary income tax rates compared to capital gains rates.
- Early Withdrawal Penalties – Withdrawals made before age 59½ typically incur a 10% early withdrawal penalty.
- Surrender Charges – Annuities often carry surrender charges for early account closure. For example, a 7% surrender fee in year one, gradually dropping to 1% by year seven (varies by contract).
- Guarantee Backing – While annuity income may be guaranteed, that guarantee is only as reliable as the financial strength of the issuing insurance company (and backed by state guaranty associations where applicable).
But here’s an easily overlooked upside to annuities.
Because of the guarantees associated with them, studies suggest that investors are less likely to trade based on market forecasts. They tend to leave their portfolios alone for the most part. And this, on average, tends to improve market returns.
So it’s not obvious whether an investor would have been better off invested in another account where they were tempted to time the market, or whether they paid fees to an annuity and resultingly felt less temptation to change their strategy.
Annuities aren’t for everyone. There are typically better, and cheaper, ways to diversify and manage risk. But for those in their late career who are risk averse, a portion of their overall allocation to a variable annuity can offer a benefit of added peace of mind due to the knowledge of guaranteed lifetime income from the insurance company.