Variable Annuities – What They are and How They Work

variable annuitiesA variable annuity is radically different from a fixed or indexed annuity. There is more risk, and there is more potential upside as well.  Here are some of the features of variable annuities:

  1. Variable annuities are sold through financial advisers and stock brokers. They are not sold by insurance agents.
  2. You can lose money with a variable annuity and there is no guarantee that you will make money. In fact you could even lose your principal investment.
  3. A variable annuity has lots of investment choices, you can allocate your money between as many as 40 investment choices (such as high growth stocks, value stocks, and corporate bonds). Depending on your investment choices, the value of your annuity can go up or down. Most variable annuities allow you to re-allocate your money without paying any additional fees.
  4. Variable, fixed, and indexed annuities have one thing in common, tax deferral. When compared to similar types of investments outside the annuity world however, the tax deferral benefit of variable annuities is often not as great as other types of annuities.  The reason why is because gains made on a variable annuity are taxed at your ordinary income tax rate, where gains on similar types of investments outside the annuity world (such as most mutual funds) are taxed at the long term capital gains rate.  For many people the long term capital gains rate is significantly lower than their ordinary income rate. You can learn more about taxes on annuities here.

The Death Benefit – A Key Difference With Other Types Annuities

All variable annuities include a death benefit. If you die before you start receiving payments from your variable annuity (during the accumulation phase of the annuity), your heirs are guaranteed a benefit upon your death. The payment is the usually the greater of the following:

  1. The current value of your annuity or
  2. Some guaranteed amount, typically your payments into the annuity minus any withdrawals.  You can also buy enhanced death benefits which guarantee your heirs will get the highest value ever recorded for your annuity, or the highest value recorded as of the last anniversary date of the annuity.

You can learn more about annuity death benefit here.

The Key Issue With Variable Annuities

A variable annuity is only as good as the investment options that are available inside the annuity. While the number of available investment options inside the annuity is important, the quality of those investment options is even more important.  For example, many annuities offer a “high-growth stock” investment choice, however the performance of the stock investment may vary widely from one annuity issuer to another. When choosing an annuity, we recommend you look at both the 5 and 10 year performance of the investment choices. How does the performance compare to a similar style mutual fund? (You can find mutual fund performance by category at www.moringstar.com.) Ask yourself the question, “Would I invest in this if it was a mutual fund?”

This lesson is part of our Free Guide to Investing in Annuities.  Continue to the next lesson here.
  Want to learn how to generate more income from your portfolio so you can live better?  Get our free guide to income investing here.

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Comments

  1. says

    Not a big fan of the variable annuity; prefer equity indexed or immediate, but the mutual fund folks have really pulled a fast one with its propaganda. The losses in retirement income for folks due to the last 10 YEARS of a bear market were predictable. The truth is the 18 year bull market [1982-2000] was an anomaly. Bear markets happen about every 7 years on average. And they do real damage to folks retirement income who are dependent on equity performance. The sequence of returns problem is the single most difficult issue to deal with for retirement planners and annuities are one way to deal with it. Now if you are an experienced and active investor when you approach retirement you can find strategies [dividend paying stocks, asset mixes] that can help you deal with this problem. But the bottom line is that the vast majority of folks aren’t experienced nor active investors as they approach retirement. And the truth is most financial planners are not either.

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