by Robert Messinger
Financial security is paramount if you’re like many of my clients at or near retirement age. Life in a volatile and unpredictable economy may make you look for investment options promising growth, income, and safety. Your need for additional income streams and a lowered risk tolerance could mean you’ll be intrigued by the concept of variable annuities.
What is a variable annuity, and how does it differ from a fixed annuity?
A variable annuity is a contract whose value changes depending on a portfolio of “sub-accounts.” Although conceptually identical to mutual funds, variable annuity sub-accounts lack the ticker symbols investors use for research and tracking. This feature means that variable annuities may be subject to greater risk than other annuities.
With a variable annuity, you get to choose from numerous investments. A variable contract consists of a principal component and a return component. Principal refers to the amount that you pay into the annuity. As the name implies, the return component is income you could make through returns from your investment choices. Returns can fluctuate, meaning payments from variable annuities skew toward the unpredictable side, unlike other annuity products such as fixed annuities.
When you purchase a fixed annuity, you essentially buy a stream of future income. This additional income stream may help supplement your pension, Social Security, or other retirement account and ensure you won’t run out of money when you leave the workforce. A fixed annuity, by contrast, is when you exchange a lump sum of cash (or series of payments) for a series of payouts lasting either for a specific time or for life.
Typically, fixed annuities are more straightforward and more accessible for seniors to understand. In a nutshell: When you buy a fixed annuity, the money grows tax-deferred and has a set interest rate. When you start the annuitization phase, the annuity issuer starts paying you. Since these payments are carefully calculated elements of your annuity contracts, they create a guaranteed, predictable income to augment your other retirement accounts.
Still, some seniors like the idea of potentially higher returns promised by variable annuities. If this describes you, you should consult an annuity expert and be aware of some of the issues inherent to variable annuity products.
For example:
- Variable annuities may have high fees and administrative expenses. Variable annuity contracts are often loaded with high fees and other costs that could eat away at your earnings. Such fees might include administrative expenses, charges for mortality and risk, and investment management fees. Over time, these expenses can chip away at overall returns and erode the value of your investment.
- Variables are confusing and complicated. As mentioned, variable annuities are known for having a complex design that is often challenging to understand. The variable lexicon is loaded with arcane terminology and definitions.
- Terms and conditions can be intricate, and your options may be overwhelming. Suppose you are considering putting a variable annuity into your portfolio. In that case, you must have a profound grasp of all your contract terms and understand the potential risks involved.
- Variable annuities expose you to market risk. If you’re close to retirement, can you afford to lose even a cent of your savings? Due to their investment component, variable products expose your wealth to market risks. Market volatility can significantly impact the performance of your sub-accounts and, thus, the income created. A variable annuity may not be ideal if you do not tolerate risk well.
- There is limited flexibility in a variable annuity. You may have little flexibility once you’ve committed to a variable annuity contract. Withdrawing cash before you reach a specific age or other stated terms can result in expensive surrender charges. Such lack of flexibility could be problematic if you have an unanticipated financial need, such as a medical emergency. Your variable contract could limit your access to your own money.
- Variables have tax issues. Variable annuities come with tax implications you must understand before purchasing. Withdrawals from annuities are usually subject to ordinary income tax rates, regardless of the initial investment amount. And, if you put a variable annuity into a qualified account such as an IRA, you’ll have to be careful to avoid redundant tax advantages, which could result in penalties.
Summing it up: Variable annuities, like fixed annuities, may offer some benefits, such as creating an additional income stream in retirement. However, you should not overlook the high fees, complexity, tax implications, and limited flexibility inherent in variable annuities.
If you are already or about to retire, it is probably wise to seek advice from a trusted financial professional. Retirement and income specialists like myself are experts in safe money strategies tailored to clients’ unique needs and goals. You and your advisor can explore all your annuity and other money options to discover which best fits your current situation and offer greater flexibility, transparency, and control of your money.
Variable annuities may work for some seniors, but you must ensure that your decision is informed and that you understand the potential pitfalls. If you are thinking about adding any kind of safe money product to your retirement blueprint, call me, and I will help you gain clarity and find the information you need to make an i
