Variable annuities are a popular choice for those aiming to combine growth potential with the security of future retirement income. They allow you to invest in a variety of funds, similar to mutual funds, and offer tax-deferred growth until you begin making withdrawals. In this blog, we’ll dive into what variable annuities are, how they work, their benefits, risks, and whether they might be a good fit for your retirement strategy.

1. What Is a Variable Annuity?

A variable annuity is a contract between you and an insurance company designed to provide growth through investments in stocks, bonds, or mutual fund-like accounts, called “subaccounts.” Unlike fixed annuities, the return on a variable annuity isn’t guaranteed; instead, it depends on the performance of your chosen investments.

• Investment Flexibility: You can select from a range of subaccounts tailored to different risk levels and growth goals.
• Tax-Deferred Growth: Your earnings grow tax-free until withdrawn.
• Income Options: When you’re ready, you can choose to receive income payments for life or a specified period.

2. How Variable Annuities Work

Variable annuities have two main phases:

• Accumulation Phase: During this period, your money is invested in subaccounts you select, similar to mutual funds, which fluctuate based on the market.
• Distribution Phase: Once you start withdrawing, you can either receive periodic payments or convert the balance into a guaranteed income stream for life or a fixed time.

3. Key Benefits of Variable Annuities

Variable annuities can offer a range of benefits for those with a higher risk tolerance:

1. Potential for Higher Returns

Since you’re investing in subaccounts linked to the stock market, there’s potential for greater returns compared to fixed annuities. This growth potential makes them appealing to those looking to build substantial retirement savings over time.

2. Tax-Deferred Growth

Like other annuities, your investment grows tax-deferred, meaning you won’t pay taxes until you withdraw funds. This allows for compounding growth, which can be a valuable feature if you’re in a high tax bracket and expect to be in a lower bracket during retirement.

3. Lifetime Income Options

Variable annuities offer flexible income options. You can choose a payout for life, helping to ensure you won’t outlive your savings. For additional security, some contracts offer income riders, which guarantee a minimum income even if your investments perform poorly.

4. Death Benefit Protection

Many variable annuities include a death benefit, ensuring your beneficiaries receive a set amount, usually your original investment, even if your account value has dropped due to market fluctuations. This feature can provide peace of mind, especially if your heirs rely on these funds.

4. Risks of Variable Annuities

While variable annuities offer growth opportunities, they also come with certain risks:

1. Market Risk

The value of your annuity depends on the performance of your chosen subaccounts. If the market declines, your account value may drop, potentially affecting your future income. If you have a lower risk tolerance, this can be a disadvantage.

2. Higher Fees

Variable annuities generally have higher fees than other annuity types. Common fees include:

• Mortality and Expense Risk Charge: Covers the insurance company’s risk and costs.
• Administrative Fees: Cover record-keeping and administrative services.
• Investment Management Fees: Each subaccount typically has an associated expense ratio.
• Rider Fees: Additional costs for features like income or death benefit guarantees.

These fees can reduce your overall returns, so it’s essential to weigh costs versus potential benefits.

3. Surrender Charges

Variable annuities may have a surrender period, often 5-10 years, during which withdrawals can incur a penalty. This lack of liquidity can be restrictive if you anticipate needing access to funds sooner.

4. Tax Implications for Withdrawals

While your investment grows tax-deferred, withdrawals are taxed as ordinary income. If you take money out before age 59½, you may also face a 10% IRS penalty, making it important to consider your timeline for access.

5. Variable Annuities vs. Fixed and Indexed Annuities

To determine if a variable annuity is right for you, it helps to compare it with other annuity types:

If you’re comfortable with market risk and seek higher returns, variable annuities could be a suitable choice. However, if you prefer more stability, fixed or fixed indexed annuities might be more fitting.

6. Who Should Consider a Variable Annuity?

Variable annuities are ideal for:

• Investors with a Long Time Horizon: Those who can tolerate market fluctuations and aren’t concerned with immediate access to their funds.
• Growth-Focused Individuals: If you want your retirement savings to grow with the market, a variable annuity can help you pursue that goal.
• Those Seeking Lifetime Income Options: Many variable annuities offer lifetime income benefits through riders, adding security to your retirement plan.

7. The Role of Variable Annuities in a Retirement Portfolio

Variable annuities can complement other investments by adding diversity and growth potential to a retirement portfolio. Here’s how they may fit:

• Complement to Safer Assets: The growth potential of a variable annuity can balance safer assets like bonds or fixed annuities, creating a balanced portfolio.
• Income Supplement: A variable annuity can supplement your other retirement income sources, like Social Security, providing flexibility and additional security.

If you’re already invested in lower-risk assets, a variable annuity can offer growth opportunities while diversifying your portfolio.

8. Important Considerations Before Purchasing a Variable Annuity

To ensure a variable annuity is the right fit, consider these factors:

• Investment Options: Look into the subaccounts available and whether they align with your goals and risk tolerance.
• Fees and Charges: Make sure the benefits justify the fees, as high costs can reduce your returns.
• Income Riders: If guaranteed income is a priority, consider adding an income rider and review its cost and terms.
• Surrender Period: Be aware of any surrender charges and whether they fit your time horizon.

Conclusion

Variable annuities offer the potential for market-based growth with options for lifetime income, making them attractive to investors comfortable with risk. However, it’s essential to understand the associated fees, potential for losses, and liquidity restrictions.

As with any investment, consider your financial goals, risk tolerance, and retirement timeline before purchasing a variable annuity. With careful planning and an understanding of how they work, variable annuities can provide growth opportunities and contribute to a balanced retirement strategy.