25 Apr Annuities Exposed: Variable Annuities [Buyer BEWARE?]
Variable annuities can be a great financial product for some people, especially when they are customized to your needs.
However, they are not right for everyone. With so many different types of annuities out there – coupled with the complexity of them – it’s hard to know what you’re buying and what’s right for you.
Especially when most annuities are SOLD.
254.8 billion dollars in annuities were SOLD in 2021 alone, according to Life Insurance Marketing and Research Association (LIMRA).
Whether you already have a variable annuity, you’re looking to purchase one, or someone is trying to sell you one, you need to know the facts so you don’t get locked into a contract that costs you way more than you bargained for.
Keep reading for a deep dive into variable annuities.
What Are Variable Annuities?
Variable annuities are a tax-deferred retirement vehicle designed to ensure you don’t run out of savings in retirement.
It’s a contract between you and an insurance company. The insurer agrees to make periodic payments to you, beginning either immediately or at some future date.
It is tied to the stock market in one form or another, and offers a range of investment options which are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three. These options are also referred to as subaccounts.
The value of your investment will vary depending on the performance of the investment options you choose. Because variable annuities are tied to the stock market, they have greater risk – as well as greater growth potential – than many other annuities.
Variable annuities are used to accumulate funds for retirement. Once you reach retirement, you have several options to withdraw your funds, depending on the contract.
How a Variable Annuity Works
There are two main phases of a variable annuity; the accumulation phase and the distribution or payout phase.
#1 Accumulation Phase
This is the savings phase. During the accumulation phase of a variable annuity, you make either a single purchase payment or a series of purchase payments.
Dollar cost averaging is common with variable annuities – with people putting in $25-50 dollars per month, depending on the contract.
Your contributions are invested in a portfolio of stocks, bonds, mutual funds, etc. These portfolios are also known as subaccounts. You can decide where to invest your contributions based on your risk tolerance.
#2 Distribution or Payout Phase
Once you reach retirement, you have several options to take distributions, depending on the contract.
Some of the normal distribution methods are:
Income payments that can be broken down into the following ways:
- Lifetime – payments for life.
- Joint and survivor – payments for life for both you and your spouse.
- Period certain – payments for a certain period (10, 20 years).
Systematic withdrawals – You choose how much, and how often you take these. Basically, it’s like taking monthly interest out of the account.
Lump sum payments – You take it all at once. The issue with this one is taxation that comes with it.
Some individual insurers may have other withdrawal options. Please be sure to read the fine print and ASK before signing on the bottom line.
[Related Read: How Are Annuities Taxed – What EVERY Investor Needs to Know]
Variable Annuity Fees
Variable annuities are well known to be loaded with fees, some of which are more visible than others. Again, each contract is different, so read the fine print.
Let’s discuss the main fees you may see in most variable annuities:
- Surrender Charges – If you surrender your policy prior to the end of the term, you will be hit with surrender charges.
- Mortality and Expense Risk Charges (M&Es) – These fees cover the risk the insurer takes in the policy, as well as fees to pay commissions. These fees are usually charged annually and are a percentage of the account value, like 1-1.5%.
- Administrative Fees – These are usually a set cost per year, like $25, to help with administration of the policy.
- Underlying Fund Fees – Each fund inside the variable annuity may have their own fees that are charged each year to manage the funds. These fees can range from 1-3% annually.
- Rider Fees or Other Fees – These are add-on fees. Your variable annuity may have specific riders or features, and each could have a fee attached to them. Examples of these riders are income riders, long-term care (LTC) riders, terminal illness riders, etc. These are usually charged annually as a percentage of the account value.
Advantages of Variable Annuities
There are quite a few advantages to variable annuities:
- Tax deferred – No taxes are due until you withdraw funds.
- Growth of your portfolio based on the investments chosen.
- Potential higher returns than fixed rate annuities.
- Growth may also potentially outpace inflation, which is important right now. because we’re in a high inflationary period.
Disadvantages of Variable Annuities
Disadvantages may include:
- Investment Risk – The investments you choose could decline in value, which could lead to lower income payouts in the future.
- Surrender Charges – Variable annuities are made for the longer term, and many have surrender charges (or early withdrawal penalties) as long as 15 years.
- Penalties – Withdrawals before age 59½ will be hit with 10% penalties from the IRS.
- Fees – The growth of a variable annuity can be held back based on the amount of fees inside it. Some normal fees seen inside this type of annuity are sales commissions, ongoing management fees, and costs of insurance charges. We have seen many of these with fees over 5%.
Also, variable annuities do not offer a guaranteed payout – like you would see with a Fixed Annuity or MYGA.
Variable Annuities Death Benefit Options
Each variable annuity contract, as well as any annuity insurer, will have specific contract language regarding death benefit options. Again, make sure to read your contract details closely before signing.
If you are a spouse of the deceased, you may have different death benefit options, including the right to continue the contract in your name to full term.
If you have a current advisor, have them run the scenario to see if this option makes sense versus transferring the assets into your name with a new annuity.
Caution: It may be in your benefit to receive a second opinion in this case.
What If You Die Before You Start Taking Payments from Your Variable Annuity?
Most variable annuities, pay a standard death benefit. The initial premiums deposited could be the starting point and would lock in as the death benefit.
It could reset annually, to account for new highs in the account or new deposits, and not decrease except to account for withdrawals.
Each account may have its own specifics on death benefits so, again, read the fine print of your contract.
What If You Die After You Start Taking Payments from Your Variable Annuity?
Depending on the annuity, payments may cease or may be converted to a lump sum payout to the beneficiaries.
Again, read the fine print of the contract and make sure what you want to happen actually happens!
Are There Any Variable Annuity Risks?
Yes, as with any investment, there is risk. The investments you choose could decline in value, which could lead to lower payouts in the future. You, as the owner, bear 100% of this risk.
How Are Variable Annuities Taxed?
Variable Annuities are taxed based on if the funds used to purchase are Qualified or Non-Qualified.
- Qualified Funds: If you use Qualified funds (like from an IRA, 401(k), etc.), you will be taxed when you withdraw the funds. It will be considered income and will tax both the principal and interest earned.
- Non-Qualified Funds: If you use Non-Qualified funds (like cash from your bank account), you will be taxed only on the interest earned. It uses LIFO – last in first out basis – for taxation.