Bajtelsmit Column: Good and Bad of Variable Annuities

Note to Editors: Vickie Bajtelsmit is a finance professor in the Colorado State University College of Business and the author of three personal finance books.

With the Baby Boom fast approaching retirement, everywhere you turn, you can find someone who has an opinion on the "best" way to save for your future income needs.

Annuities are financial products that provide a steady future income and, for this reason, are often recommended as a component of a retirement plan. There are many variations, so there isn’t enough space in this column to do more than give you the basics. No matter what type you are considering, you should do your homework and be sure it’s right for your circumstances before buying.  Although variable annuities are the most popular, they are also the most problematic for reasons I’ll explain here.

Let’s start with the basics: An annuity is a contract that entitles you to receive regular periodic payments, either beginning at the date of purchase (immediate annuity) or at some future date (deferred annuity), such as when you retire. The payments can be for a set period of time or for your whole life. You buy the annuity either with a single lump sum payment or a series of smaller payments over time.

Annuities are also classified as either fixed or variable. A fixed annuity pays a set rate of interest, whereas a variable annuity’s rate of return depends on your investment choices.

When you buy a variable-annuity, you choose how to invest your premium payments, usually across mutual funds that differ in risk and return characteristics. Performance of those investments will impact both the buildup of the fund prior to your retirement date and your payout during the retirement period. By investing the funds in higher-yielding assets such as stocks, the eventual payment you receive in retirement may be higher.  However, as many investors have now learned the hard way, you can lose money in the stock market as well.   

Variable annuities have been aggressively marketed based on seemingly attractive features that distinguish them from other investment alternatives-death benefits, guaranteed of rates of return or minimum withdrawals, long-term care benefits.  But be forewarned-you don’t get something for nothing.  

The costs of all those bells and whistles reduce the accumulated value in your account and also the rate of return you earn on your investment. It is often less expensive to buy the insurance products separately.

Variable annuities also tend to have very high investment-related loads, expenses, and fees. In total, the costs may be several times those imposed by no-load mutual funds and can outweigh the tax advantages in the long run.

The tax advantages of deferred annuities are similar to qualified employer retirement plans and IRAs.  Most people should make the maximum tax-deductible contribution to their employer retirement plan before considering the purchase of a deferred annuity.

In both types of investments, you accumulate wealth on a tax-deferred basis and pay no taxes on the income and investment gains until the time of withdrawal. A disadvantage of both is that the capital gains on invested assets end up being taxed at your ordinary income tax rate at withdrawal instead of the lower capital gains tax rate. If you withdraw the money prior to age 59 ?, you will pay a 10% penalty.

Variable annuity contracts can differ on many dimensions, including fees, expenses, investment options, death benefits, payout options, guarantee of payment period, and more. This information will be detailed in the prospectus for the investment, which you should read carefully and compare to other investment options before making the decision to purchase.