How does a variable annuity work?
FPA member Richard Coles, CFP®, CDFA™, of D. Scott Neal, Inc. said the following:
“A variable annuity is a contract issued by an insurance company. In exchange for your lump-sum payment, you will receive regular periodic payments for a specified length of time, or for the lifetime of the purchaser(s). This annuity might begin straight away but is more likely to be deferred to a future date.
“The term ‘variable’ means that the lump-sum payment is invested into mutual funds or option contracts and, as a consequence, the value of the annuity will fluctuate as a result of the performance of the underlying mutual funds or option contracts.
“A benefit of a deferred annuity is that before the periodic payments start the annuity policy can accumulate earnings on a tax-deferred basis. When annuity payments begin, they will consist of the return of principal (this is your original investment being returned to you and is therefore tax free) and interest, which is taxable.
“Before you consider an annuity as an investment due to its tax advantages, please first consider retirement plans such as Individual Retirement Accounts (IRAs) or 401(k) plans as the tax treatment of retirement plans is nearly always more favorable.
“Other reasons investors might consider an annuity is:
- Because the insurance company offering the product might have some sort of investment protection built into the annuity. An example might be that the variable annuity offered will go up if the stock market increases, but is ‘guaranteed’ not to go down if the stock market falls. The word guaranteed is in quotes because the guarantee is only good while the insurance company is financially strong enough to cover it.
- The contract has a number of attached benefits (called rider benefits) such as liquidity for nursing care and terminal illness or a guaranteed living benefit.
“Disadvantages of variable annuities are often the high charges compared to other investments, the inability to get your money back quickly or cheaply, and the complexity that, in my opinion, serves to mask the high expenses.”