Understanding Variable Annuities

By Cathy DeWitt Dunn

A variable annuity is a contract between you and an insurance company. You purchase a variable annuity by making either a single or series of purchase payments after which the insurer agrees to make periodic payments to you, beginning either immediately or at some future time.(1)

The value of your annuity will vary depending on the performance of the investment options you choose. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.

As you make purchase payments you can allocate a percentage to a number of investment options. For example, you could designate a portion to a bond fund, a different portion to a U.S. stock fund, and the remainder to a money market fund. The money you have allocated to each mutual fund investment option will increase or decrease over time, depending on the fund’s performance.

As with other types of annuities you can purchase features such as death benefits, lifetime income, nursing home benefits, and items like bonus credits where the insurer matches some percentage of your purchase payments. Variable annuities also include surrender charges if money is withdrawn faster than allowed by the contract.

When the payouts begin, you may receive your purchase payments plus gains as a lump sum payment, or you may decide to receive payments at regular intervals. If you choose to receive payments at regular intervals, you may have a number of choices of how long the payments will last.

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Variable Annuity Pros and Cons

The principle advantage of a variable annuity is the ability to move assets within the annuity from one investment type to another without having to pay tax on the gain of the asset sold. Since annuities are purchased for long term asset appreciation, it is likely that over time different investment types will outperform others thus being able to switch types without tax penalties can be an advantage. However if losses occur then losses cannot be used to offset gains. The value of the investments accumulates tax free and is taxed as ordinary income when withdrawn.

Variable Annuity Risk & Fees

The most obvious disadvantage of variable annuities is that the investment is at risk. There is no limit to the possible loss of the investment as there is no limit to the possible gains. A less obvious disadvantage of variable annuities compared to other types of annuities is the cost or fees applied. The managers of the mutual funds charge fees as do employees of the insurance company that manage your account. In addition there are administrative fees, mortality and expense risk charges and fees for any additional benefits purchased. It is not uncommon for fees to total 4% or more annually.

Variable Annuity vs. Mutual Fund

Many financial advisers suggest rather than purchase a variable annuity, it is better to just invest directly in the mutual fund and avoid all of the fees and achieve the greater tax advantage offered by the tax treatment of long term capital gains and losses. In fact Suze Orman has a video expressing a similar thought seen at “No to Variable Annuities Says Suze Orman“.

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To learn more about annuities and how they may fit into your retirement income plan, we urge you to watch our free educational video series. Then, give us a call at (972) 473-4700 to discuss your specific situation.

(1) Annuity product guarantees rely on the financial strength and claims-paying ability of the issuing insurer.

Disclosure: Please consider the investment objectives, risks, charges, and expenses carefully before investing in Variable Annuities. The prospectus, which contains this and other information about the variable annuity contract and the underlying investment options, can be obtained from the insurance company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest. The investment return and principal value of the variable annuity investment options are not guaranteed. Variable annuity sub-accounts fluctuate with changes in market conditions. The principal may be worth more or less than the original amount invested when the annuity is surrendered.

DeWitt & Dunn does not provide tax/legal advice. Please consult with the appropriate professional.