Traditionally, annuities offered a fixed and conservative return on your investment. They were safe and reliable, but about as exciting as last night's stale beer and cold pizza. In recent years, variable annuities have upped the ante. Rather than restricting your investments to its own stodgy, conservative portfolio, variable annuities enable you to invest in stocks, bonds, mutual funds and other mainstream products.
Annuities might look like other investments to the casual observer, but they're actually a sort of mutant life insurance contract. Legally they're very similar, but instead of paying out a lump of cash while you die they pay out an income while you live. Ordinary or "fixed" annuities pay out a guaranteed minimum rate of return, though the insurer will increase your returns when its portfolio performs well. Variable annuities let you pick your own investments instead, so if you want higher returns you can invest in stocks directly, or indirectly through mutual funds or exchange-traded funds (ETFs).
How It Works
In some respects, a variable annuity works much like an IRA. Both are the financial equivalent of a magical invisibility cloak, shielding your investment income from taxation. You can hold a wide range of investments within the annuity, though your specific choices will vary between insurers and individual annuity products. Mutual funds, bonds and bond funds and equity stocks are all options. If you have a large lump sum to invest, you can choose a diversified portfolio of individual stocks. For small investors, it's better to put your monthly payments into mutual funds or exchange-traded funds. They'll select a nicely diversified portfolio for you, because that's what they do.
Like any other investment, variable annuities have their positives and negatives. First, it's important to remember they're variable. That means they go down as well as up, so if you're seriously risk-averse this probably isn't the annuity for you. Many insurers cushion the potential pain from down markets by offering a guaranteed minimum return on your investment. That's a good thing, but they often compensate by capping your upside returns during strong markets. Over a period of decades, that could cost you a lot of retirement income. Annuities also have high costs, and limit your liquidity.
Liquidity and Fees
Liquidity is an investment term referring to how easily and cheaply you can get your money out if you need to. It's not a strong point for annuities, which are intended as long-term investment. During the first several years, you'll pay surrender fees that can start at 20 percent or more, then decline over time. You'll also owe taxes on any profits you've made, and the IRS levies an additional 10 percent penalty if you withdraw before you're 59 1/2. Administration fees are also high with annuities. Not only are you paying fees to the investment fund, you're paying fees to the insurer as well. These can seriously sap your earnings.
Making Your Choice
Like any other product, variable annuities are not innately good or bad investments. They either suit your needs or they don't, and that comes down to smart shopping. Understand your needs and goals first, or you won't know if a variable annuity meets them. Shop aggressively, comparing the investment options and management fees of the annuities themselves and the underlying mutual funds. Take time to understand the surrender fees charged by each company, and how they decline over time. A relatively modest investment in this kind of research can make a large difference in the eventual size of your nest egg.
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