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One of the biggest worries for older investors is the prospect of outliving their assets. With many people in the developed world now living 20 or more years past retirement, those fears are often justified.
Annuities have long been a popular strategy for managing this so-called “longevity risk.” A standard fixed annuity is an insurance contract that allows an individual to pay premiums – either in a lump sum or by monthly installments – and obtain set income payments for life.
However, one drawback for some consumers was the modest rate of growth on contributions. Historically, the internal rate of return has been close to long-term Treasury bond yields, often in the low single digits. In other words, you’re lucky if the money you put in keeps pace with inflation.
So over the past couple of decades, the insurance industry has been more creative with an alternative product with greater growth potential. With a variable annuity, you select multiple sub-accounts, which are essentially mutual funds that invest in stocks, bonds or other instruments. The value of your account – meaning the amount of your payments during the withdrawal phase – depends on the performance of these underlying investments.
Those who pay in for a long enough period before making withdrawals, or annuitizing, often do better than the fixed returns they’d otherwise receive. That’s particularly true if they select investments that suit their age and financial goals. But if the markets take a dive, there’s also the possibility that your account could lose value.
The Good, the Bad and the Ugly
Variable annuities (see Getting the Whole Story on Variable Annuities) share certain features with IRAs and 401(k) plans, including the tax-deferred growth. As a result, you can hold off paying taxes on gains until you start receiving payouts. Like these other retirement plans, you normally can’t make withdrawals before the age of 59½ without incurring a steep 10% penalty.
Annuities may also provide benefits that other retirement vehicles don’t have, such as a death benefit for loved ones. Typically, the person you select as your beneficiary will receive either the balance of your account or a guaranteed minimum payment.
But, annuities have some less appealing characteristics as well. Among them is less-favorable tax treatment once you hit the annuitization phase. Unlike IRAs and 401(k)s, which are subject to lower capital gains taxes, any growth in your annuity above and beyond your contributions is treated as ordinary income. If you’re in a higher tax bracket, that aspect alone can take a huge bite out of your earnings.
Further eroding your account are the notoriously high fees that insurance companies charge their annuity customers. You’ll really feel the squeeze if you take money out of the policy within the first few years and incur a “surrender” charge. The amount of this fee is usually based on the amount you withdraw, with the percentage gradually decreasing over a period over several years. For example, taking funds in Year 1 may incur an 8% charge, while a withdrawal in Year 8 only encountering a 1% hit.
Figure 1. Example of surrender charges associated with a variable annuity.
Source: Atlas Capital Advisors, LLC
Even if you don’t take money out during the surrender period – anywhere from six to 10 years after signing up, depending on the annuity – you still face pretty stiff annual fees. These can include:
By contrast, many investment companies offer no-load or index funds (see No Load Vs. Index Fund: Is One Better Than the Other?) with fees less than 0.50%. Even actively managed funds look comparatively cheaper, with average expense ratios of around 1.25%.
When Variable Annuities Can Make SenseBecause of the additional costs that annuities tend to incur, experts generally advise against putting these contracts inside an IRA or 401(k). These plans already offer tax-deferred growth; there’s no benefit to doubling up on this benefit. Furthermore, if you put stocks and bonds into these retirement plans instead of an annuity, you’ll be paying a lower capital-gains rate on any earnings once they’re withdrawn.
Where variable annuities may be worth a look is if you’ve maxed out your contributions to other tax-advantaged accounts. If that’s the case – and you want the peace of mind that lifetime payments provide – these insurance contracts merit some consideration.
Your best bet is searching for one with relatively low costs from an established company with a strong financial rating from agencies like A.M. Best and Moody’s.
The Bottom LineOn the surface, variable annuities look like an attractive way to plan for retirement, with tax-deferred growth, payouts for life and even a death benefit for your family. But because other retirement accounts, such as IRAs and 401(k)s, offer better tax treatment and lower fees, most people will probably want to start there.
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