Course 401: Variable Annuities
Variable Annuity
In this course
1 Introduction
2 What's a Variable Annuity?
3 Fixed Immediate Annuity
4 Fixed Deferred Annuity
5 Variable Annuity
6 Equity-Indexed Annuity

Pros

  • For those with long time horizons, the ability to enjoy equity market participation is valuable.
  • Variable annuities also offer tax-sheltered growth and unlimited contributions for those who have maxed out their tax-deferred options.
  • Those who layer on guaranteed withdrawal and income benefits also buy themselves income and a measure of principal protection.

Cons

  • Variable annuities often have several layers of costs, including mortality and expense charges, underlying fund costs, administrative expenses, and fees for option benefits. Surrender charges may also apply if you need to withdraw assets early in the life of your contract, usually within the first five years.
  • Tax treatment upon distribution is also unattractive relative to stocks and stock mutual funds held in taxable accounts for at least a year.

Unlike fixed annuities, variable insurance products give you a level of control over your investment selections--including the opportunity to invest in stocks. The account value of a variable annuity fluctuates with the direction of your investments. The ability to own stocks makes a variable annuity a better choice when asset growth is a priority, though it can be a mixed blessing when stocks are dropping. Variable annuities also come with insurance components, including a death benefit payable to your heirs if you die before you annuitize. VA investors can also layer on other so-called living benefits, such as guaranteed minimum withdrawal benefit riders, which allow VA owners to withdraw a fixed percentage of the benefit base each year until death.

As with the fixed deferred annuity discussed above, a deferred variable annuity (by far the most common type of VA) functions something like an IRA, though you must choose your investments from a set menu of mutual funds, called subaccounts. VAs receive generally the same tax treatment as fixed deferred annuities: Your contributions aren't tax-deductible, but your investments can compound on a tax-deferred basis. You'll also owe ordinary income taxes upon withdrawal. (More on this in a moment.)

The biggest knock against VAs is their several layers of costs. The management costs associated with running the investments are, in some cases, even lower than mutual fund management fees. But because annuities offer a death benefit--usually guaranteeing to provide your heirs with an amount equal to your initial investment if you die before you annuitize--they charge an additional expense called a mortality and expense charge. That element of protection can provide peace of mind.

But in reality, few VA owners end up using their death benefits, and the associated costs can be a drag on your long-term returns. You'll also pay additional fees for any features you layer on, such as guaranteed minimum withdrawal benefits. When all of those expenses are factored in, you can easily pay much more than you would for a comparable mutual fund coupled with separate insurance coverage. Finally, some VA policies have onerous surrender charges if you need your cash early in the life of your policy. (VAs also typically have a free look provision, however.)

Next: Equity-Indexed Annuity >>


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