Annuities are one of the most heavily marketed financial products to retirement-age people. They are often sold as the solution to a retiree’s greatest fear: outliving your money in retirement. But, with the potential for guaranteed income from an annuity, do you have to sacrifice the potential for growing your money?
Not if you buy a variable annuity. A variable annuity acts as a tax-deferred account in which you invest money, and then receive payments in retirement based on the growth of that invested money.
However, with that greater reward potential comes greater risk – and often greater costs.
How variable annuities work
A variable annuity allows you to choose mutual-fund-like investments in what is called a subaccount, similar to a typical retirement account like an IRA. The payments you receive depend on the performance of the investments you choose.
Unlike fixed annuities, variable annuities don’t provide a guaranteed payout. People choose this annuity for the potential to receive a larger payout than other annuities. However, that potential comes with greater risk.
You can lose money
There is no guarantee you will earn a return on the investments you choose. In fact, there is a risk that you will lose money. If the investments you choose decline, so does the value of your annuity, which means a lower payout to you.
The risk of losing money is further compounded by surrender charges and higher fees that will increase losses in down markets. If you don’t like the performance of your investments, you would have to pay substantial fees to withdraw your money.
Compare that to simply investing in an IRA account in which you have much greater control over your investments and the fees you pay.
You are charged a variety of fees
Variable annuities are like an onion wrapped up in layers of high annual fees. The average mortality and expense charges, a fee insurance companies charge to compensate for various risks they assume under the contract, is 1.25%. Variable annuities also charge for compensation of record keeping and other administrative expenses, typically around 0.28%.
Then there are the underlying investment expenses. Fees charged by funds in the sub-account is part of the normal cost of investing in these funds. The average variable annuity investment expense is 0.97%, but it could be more. These fees may also include sales charges, as well as 12b-1 fees used to pay brokers for distributing the fund shares.
Add them up, and you could be paying more than 3% in total expenses a year, or much more as you purchase additional riders to guarantee income, principal, death benefits, inflation adjustments, etc. The high cost could take a huge bite out of your retirement nest egg, and in some cases even cancel out some of the benefits of an annuity.
Guaranteed growth on the account may not be what it seems
A variable annuity may offer a guaranteed growth rate, but that growth rate is usually not credited to the original principal invested. The guaranteed growth rate generally applies to a “benefit base account.” This benefit base account is comprised of the original investment value of the contract, plus interest generated from the invested money at the guaranteed growth rate. It is grown with interest only for the purposes of calculating the future income.
The benefit base account is completely separate from the invested principal, which will fluctuate in value. Hence, the term “variable.” The only way to receive the value of the benefit base account is to annuitize the contract (i.e., choose to receive payments for the rest of your life, according to an actuarial calculation). If you instead decide to terminate your annuity contract, you will typically receive the value of the invested principal and not the benefit base account.
In the off chance your principal is guaranteed, you are typically limited to very conservative portfolio options to limit the risk to the insurance company of suffering a large market loss. You are usually paying more in fees through the purchase of an additional rider for this benefit as well, and your long-term growth will be lower as a result of the very conservative investments.
Does a variable annuity make sense for you?
Everyone’s financial situation is different, so every financial product isn’t right for everyone. Annuities can offer attractive features, but they are also very complex and can come with critical disadvantages that are easily lost in the fine print.
Instead of a variable annuity, for example, you could just invest money into a regular investment account without all the added costs or strings attached. With the right asset allocation, you could still receive some growth while preserving your money to create a steady income stream.
Therefore, when considering a variable annuity, be sure you understand its various features and consider the counsel of a financial adviser about whether it’s right for you.
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