Over the past several years, variable annuities have returned better results for investors than fixed-rate annuities. But an increase in returns comes with a cost: added risk and volatility. There's no way to predict the future return of any investment, but in the typical investment guide period of 10 years, a variable annuity can possibly yield up to 12% per year, which is clearly more than a fixed-rate annuity would ever offer. Even after deducting taxes and fees, variable annuities can play an important role in an investor's portfolio. Be careful, though. Like all equity investments, variable annuities can also lose value.
What are Variable Annuities?
It's often hard to understand how variable annuities work because they are an investment product offered by life insurance companies. Like all annuities, a variable annuity is a contract between an investor and an insurance company. The contract outlines what the investment will return and how the investor will benefit from that return. While variable annuities can be both immediate and deferred, they are almost always sold as deferred. The deferral of taxes and distributions is what makes variable annuities so attractive. They can be funded with either pre- or after-tax dollars that will grow tax-free until distributions begin. And, variable annuities are almost never included as part of one's assets if sued. The contract cannot be broken, regardless of a financial judgment against the annuity owner.
Unlike other life insurance products, variable annuities invest in several financial instruments. The insurance company may invest in securities, mutual funds, and bonds, and is therefore subject to the rules and regulations of the Securities and Exchange Commission (SEC) as well as state insurance boards. Life insurance agents who recommend and sell variable annuities to their clients are required to be licensed and also must be registered and in good standing with the National Association of Securities Dealers (NASD). Agents must also pass the Series 6 or the Series 7 general securities exam and all other exams required by the state in which they do business.
Federal and state authorities regulate variable annuities because the investor is responsible for the investment risk. That means if you are considering a variable annuity, you need to make sure the underlying investments are suitable from both an asset allocation and diversification perspective. When you choose to invest in variable annuities, you alone bear the risk for loss.
Using Variable Annuities for Tax-Deferred Savings
While immediate annuities can be variable annuities, they are usually bought as deferred annuities in order to increase tax-deferred savings for retirement. During the accumulation phase, money is contributed and all earnings are tax-deferred. It's important to note that one of the most beneficial features of a deferred variable annuity is that it grows tax-deferred even if it's funded with after-tax dollars. If you have money in a regular savings or brokerage account, you're paying taxes on the earnings each and every year. This reduces the amount of money that can accumulate and compound. Tax-deferred accounts that are started early in your career can grow significantly larger over the time.
Once distributions from the annuity begin, you can choose to take the payments as a lump-sum distribution, or in a specific amount for a set period of time. You can even choose to receive guaranteed payments for life. Obviously, the amount of the payouts is determined by the length of time you'll be receiving them. In other words, if you choose to receive payments monthly for 20 years, the distribution might be higher than if you choose to receive payments for the rest of your life.
A Death Benefit Protects Your Investment and Your Loved Ones
Unlike almost all other financial and investment products, a variable annuity contains a death benefit that is somewhat similar to a standard insurance policy. If you are married or have children and are concerned that you might not live until payouts begin, an annuity with a death benefit should be considered. When you purchase a variable annuity with a death benefit, you can name a beneficiary who will receive the premium if you die before receiving payments. The amount that is paid back to the beneficiary will vary depending on the insurance company, but at the very least, most companies will return the amount of the premium even if they don't pay what has been earned.
You and your beneficiary should understand, however, that unlike a death benefit on a life insurance policy that is paid tax-free, the death benefit that is paid on a variable annuity will most likely trigger a taxable event. Depending on your relationship to the beneficiary – spouse, child, nephew, etc. – and whether the annuity was purchased with pre-tax or after-tax dollars, the death benefit will usually be subject to several federal and state taxes.
Choosing a Variable Annuity Over Other Investment Options
If you choose to invest in a variable annuity, it should only represent one part of your entire portfolio. While variable annuities do come with some guarantees that other investments do not, don't put any more than 15% – 20% of your entire portfolio in any annuity. Mutual funds, stocks, bonds, real estate, and cash must also be part of your portfolio. While these types of accounts are taxable if purchased with after-tax dollars, they represent diversification. Once you begin taking distribution on other accounts after retirement, the assets can be quickly depleted. If the mandatory distribution is $2,000, the account value is reduced by that amount each year, which leaves less to compound over time. You might run the risk of depleting an account long before you can afford to. With a variable annuity, however, you can set up payments for life, which eliminates the risk of outliving your retirement savings.
Variable annuities can be beneficial for if you have the time and expertise to research what you're purchasing and from whom. You can save money by investing directly, but it's always a good idea to discuss your overall financial plan with a qualified professional who can offer advice. An annuity is not something to enter into lightly. Once you purchase it, your money will be locked in for the duration of the contract. You need to make sure that you have other liquid assets that can be cashed in quickly should you need to do so. Variable annuities are much more of an investment product than an income-producing product, and are really therefore more suitable if you have a longer time horizon and greater risk tolerance.
Don't delay. Get a live report of the best annuity products and rates on the market today. It only takes a few minutes, Start Now.
More Annuity Guidance
- Annuity Investment Guide — The complete guide to annuity investing.
- Fixed Annuities — Learn about the ins and outs of fixed annuities.
- Indexed Annuities — Learn about the ins and outs of indexed annuities.
- Immediate vs Deferred Annuities — Learn how to choose between annuity types.
- Annuity FAQ — Answers to commonly asked annuity investment questions.