When planning for retirement, you’re faced with a variety of investment options – each with different requirements, costs, and limitations. Today, I’ll talk about variable annuities, an option that some investors find intimidating due to their complexity.
First, let me start off by explaining what a variable annuity is. It’s a financial planning tool that can provide a guaranteed income stream during your retirement. Variable annuities were introduced in the 1950s as an alternative to fixed annuities, and to compete with rising popularity of mutual funds.
A variable annuity consists of subaccounts that are essentially mutual funds managed and operated by investment firms and insurance companies. The number of subaccounts within a variable annuity can vary from a few to a few hundred.
So how does a variable annuity work and what are the pros and cons of investing in one?
The insurance company that you choose to do business with invests your money in mutual fund subaccounts of your choice. You can begin withdrawing your money once you’re 59 1/2 years old. Any withdrawals before that will be subject to a 10% penalty.
The main advantages of a variable annuity include:
- Unlimited contributions. Unlike your 401k or an IRA, variable annuities have no limit on how much money you can put in them.
- Tax-Deferral. All income you earn is tax-deferred until you begin making withdrawals at retirement
- Guaranteed return of funds at death. The insurance associated with deferred variable annuities makes it so if you pass away before annuitizing, the insurance company will guarantee payment of the total value of your variable annuity or entire amount of your premiums paid in to your designated beneficiary or estate.
- The potential for investment diversification. Most variable annuities offer a variety of mutual funds to meet your individual investment goals and comfort level with risk.
Some of the main disadvantages are:
- Market risk. The biggest potential disadvantage to variable annuities is the possibility of a decline in the market value of your investments.
- Requires hands-on investing. With a variable annuity, you can’t just make your investments and forget about them. You need to monitor the financial markets and modify your mutual fund investment choices as conditions change.
- Insurance cost. To guarantee the return of your principal, the insurance company is naturally going to charge you a premium. The average variable annuity insurance cost is currently 1.21%.
The bottom line: Variable annuities can offer many benefits to investors. But it’s always a good idea to consult with a financial advisor before making any major investment decisions.
If you decide to go with a variable annuity – do your homework. Evaluate your mutual fund choices and diversify your asset allocation among several funds with the best track record.
You certainly don’t want to purchase a variable annuity with the anticipation of significant investment growth, then select mutual funds that cannot deliver. Yet many people buy a variable annuity policy and then leave their assets entirely invested in money market funds. Be sure you get the most out of your investment by being proactive in evaluating your investment choices.
Lastly, as part of your homework, be sure to check the insurer’s safety rating on the Weiss Ratings website.