Variable Annuity: Pros & Cons
Variable annuities are complex insurance contracts that can be useful for some people as a way to save for retirement. However, these products often come with high fees and expenses, which may make them unsuitable for some investors. Understanding the pros and cons of variable annuities is critical for making smart decisions about whether they are right for you.
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Types
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The two main kinds of annuities are fixed and variable. A fixed annuity makes a payment to the account owner based on calculations made at inception. A variable annuity's payment may rise or fall with the performance of its underlying investments.
Function
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The purpose of a variable annuity is to provide an income stream for life, or another defined period. The variable nature of the contract allows funds to be invested in mutual fund-like sub-accounts. The hope is that these investments will do well enough so that the owner will get a higher income payment. However, if the investments do not perform well, the payment can actually be lower.
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Considerations
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Since variable annuities can increase or decrease in value, it's important to consider whether a variable annuity is the right investment. While guaranteed income is valuable, the investment expenses in variable annuities are high, so good performance may be hard to achieve.
Warning
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While variable annuities can provide assurances about income, they do so by tightly restricting access to the underlying funds. Most variable annuities have a steep "surrender charge" if the investor changes her mind or needs the money for something else. Surrender charges of 7 percent or more in the first year of a contract are not uncommon. Thus, an investor who buys a variable annuity and then withdraws funds during the first year will pay a 7 percent penalty on any amount withdrawn. This is in addition to any tax penalty that may arise if the account holder is under the age of 59 1/2.
Potential
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Some variable annuities come with other guarantees besides the income payment. For example, some annuities come with a guaranteed minimum income benefit that provides that the investor will get a certain income even if the underlying investments lose money. In this case, the investor may be able to take more risk than he normally would with the money and if things go his way, he could have significantly more income.
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