While I didn’t have a whole lot of good things to say about Fixed and Equity Indexed Annuities, I do have a few more positive things to say about Variable Annuities. I actually see some real benefits to some of the Variable Annuity products out there, and have found them to be the best choice for a portion of some of my clients’ portfolios. That said, you must make a very informed decision, taking all aspects of your personal situation into consideration before investing in a variable annuity.

Variable Annuities (VA)

Variable Annuities are a creation of insurance companies that allow you to invest your money in the market while still keeping many of the benefits and promises of an annuity. When you invest in a VA you are given a choice of “sub-accounts” in which you can allocate the funds. Usually you are able to choose from a wide range of investments, from money market accounts to emerging market funds, and everything in between. Unlike fixed and equity indexed annuities, the value of your account will go up and down in relation to the sub-accounts that you have chosen to invest in, and there is the potential to lose a lot of your principal. On the other hand, there is much more potential for growth than in the other types of annuities – 100% of the growth of the sub-accounts that you (or your advisor) have chosen.

Guarantees

The industry is coming up with a new guarantee every month, or so it seems. I cannot possibly get into the details of these promises without creating a monster of an article. I will try to just give you a taste of the types of things that are available.

First, nearly all VAs have a “death benefit,” which usually gives the promise that if you die and the value of your account is less than the amount you have invested, your heirs will receive the amount invested. So if you had invested $25,000 and the market had gone way down and now you only have $12,000, the company will pay your heirs the full $25,000. Of course, there are variations out there, but this is the idea.

Next, there are a bunch of “living benefits” available as well (living, meaning you don’t have to die to get the benefit). One such benefit is a promise that if you leave your money in the annuity for a minimum number of years (often 7 or 10) you will always be able to withdraw an amount equal or greater than your investment. So in the example I used earlier, you would be able to get $25,000 from the company even when the value is only $12,000, to use however you want to.

Another guarantee out there is a promise that the value of your account will grow at least a certain amount (usually between 5 and 8% per year) for 10 years, no matter what the market really did, and that you will be able to withdraw a percentage of that guaranteed account value (again between 5 and 8% per year) for as long as you live (as long as you don’t withdraw more than that). There are so many other variations along the same vein as these, but hopefully this gives you an idea.

The Benefit

The benefit, in general, to these guarantees is that a person is able to invest in the stock and bond market and participate in the potential growth of those markets while minimizing the risk of losing their principal. For some this is important because they really need to get the kinds of returns that can only be found in the stock market, but are afraid to or unable to put their principal at risk. Also, with some of these guarantees there is the promise that you will never run out of money (which is one of the biggest risks and likelihoods that I see for most people). In addition, there are also the benefits of tax deferral while the money is in the annuity.

The Downside

First, you will pay higher fees, generally, in an annuity than you will when investing in similar mutual funds. Often these fees are 1-3% higher. The more guarantees you buy, and the bigger the promises, the more you will pay. Remember, you are in essence buying insurance on your investment.

Also, you are locking up your money. You will pay tax penalties on the growth if you pull the money out before you are 59 ½ and insurance company penalties on the principal if you pull it out before the contract allows. These penalties can really add up. At the same time, the penalties might be a good thing for some people if it keeps them from spending the money before they should.

Last, each of these “promises” are only good if you abide by the rules. Often, the bigger and better the promise is, the more restrictive the rules are. In addition, these rules are often the least understood part of the product by both the salesman and the client. Great effort must be given to truly understand the terms of the guarantee and all of the implications that future decisions and circumstances may have. I think that many people invest in these products thinking that they understand, when they really don’t and really shouldn’t.

In Conclusion

I am afraid that I have glossed over the ins and outs of VAs without giving enough detail to be helpful. I could go into depth on the benefits and risks of some of these guarantees one at a time in future articles, if there is interest. You will have to let me know if there is enough interest out there in doing that.

I do believe that there are some great VA products which could really be the best choice for some people. I also believe that they are sold to a lot of people who would be much better served in a different investment. The details of each person’s complete financial picture must be carefully analyzed to determine if a VA is a good fit.

Read Part One | Read Part Two | Read Part Three

* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional.

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