How to Buy a Variable Annuity to Supplement Your Retirement Income

Three Parts:Deciding if a Variable Annuity is Right for YouFinding a Reputable AnnuityConsidering Other Options

An annuity is an account an investor pays into during a contribution period and receives distributions from after retirement. They come in several varieties, but a variable annuity is an annuity where the principal is invested and is allowed to grow or shrink in accordance with the performance of the investment. While variable annuities do have the potential to produce more income than other types of investments, they’re also subject to many fees and restrictions lessening their value as an investment vehicle. Indeed, many financial experts advise against them altogether. If you’re considering purchasing a variable annuity, make sure you calculate their costs relative to other investments and are aware of their terms and conditions.

Part 1
Deciding if a Variable Annuity is Right for You

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    Decide whether you are comfortable with the risk. Unlike a fixed annuity, which offers a defined payout, a variable annuity takes your initial investment and places the money in a variety of investment vehicles, mainly mutual funds, but also bonds and money market accounts. This gives your initial investment the opportunity to grow. In theory, this leads to a higher payout when retirement comes than an investor would find in a fixed annuity.[1]
    • The opportunity to grow wealth offers a corresponding opportunity to lose it. Just because some mutual funds make money doesn’t mean others will. There are a host of well-capitalized mutual funds that have lost well over half of their value over the last ten years. [2]
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    Take tax ramifications into account. Like many retirement investments, variable annuities offer the advantage of tax-deferment, which means that you don’t pay taxes on the money invested until you begin to receive distributions after retirement.[3]
    • Nonetheless, a variable annuity doesn’t offer the same tax advantages as other retirement accounts. Any withdrawals beyond the principal investment are taxed as ordinary income. Although this puts it in the same class as 401(k)s and IRAs, it is a disadvantage compared to Roth IRAs (which are untaxed) and sales of stocks and bonds, which are taxed at the lower capital gains rate.
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    Be aware of the consequences to your heirs. If you bequeath your annuity to your heirs, they will be liable for tax on all of the value gained since you began the annuity (the cost basis). This is in contrast to other bequests, like stocks, which allow for a “step-up” in value to heirs. [4]
    • For example, if your initial investment in a variable annuity was $10,000 and the value at the time of your death was $100,000, that’s a $90,000 gain. The heirs to an annuity would be liable for the tax on the full $90,000. In contrast, had you invested that same money in a mutual fund with the same gains, your heirs would be liable for none of the $90,000 gain. They would only be liable for whatever their own gains are.
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    Make sure you won’t need to get at the money anytime soon. Variable annuities have a host of penalties associated with early withdrawals. These penalties add up quickly, and if there’s any chance you’ll need to make withdrawals from the account before the allowable period, they can be a very poor investment.[5]
    • Since variable annuities are tax-deferred, you aren’t allowed to make any withdrawals at all prior to age 59 ½ without a 10% tax penalty.
    • Annuities also have a “surrender period,” which is a period in which the investor agrees to surrender the money in the account to the investor. Surrender periods vary by annuity, but they can be anywhere from five to seven years. Any withdrawals during that period are penalized according to the age of the account. So if you were two years into a seven year surrender period, the withdrawal would be penalized at a 5% rate.
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    Prepare for other associated expenses. Variable annuity fees don’t end with the surrender period. There are also mortality fees, expense fees, administrative fees, and extra charges for guaranteed minimum income after payout and fees for increased death benefits.[6]
    • Mortality and expense fees are fees of about 1.5% per year help the insurer hedge against the risk of your early death. Administrative fees will often add another .6% per year to the total.
    • Guaranteed minimum income benefits and stepped up death benefits allow you or your loved ones to lock in payments above your principal investment even in the case of loss. They are typically up to 2% and .6% per year, respectively.
    • Another way variable funds hide costs is by charging different rates for the mutual funds within the annuity. These are called “subaccount fees,” and they are fees charged by the variable fund or the underlying mutual fund to manage the mutual fund, and they can be more than 3% per year.

Part 2
Finding a Reputable Annuity

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    Find a reputable insurer. Variable annuities are problematic financial instruments under the best of circumstances, so if you’re considering a purchase, you should first find a stable and highly rated insurer. The specific terms of any annuity are always secondary to finding an annuity from an insurer likely to be in existence when you need the payouts. It would be pretty difficult for a layman to evaluate the financial strength of an insurer. Luckily, you don’t have to try. So called “ratings agencies” actually do the work of determining an insurer’s financial strength for you. Some of the most prominent and well-respected ratings agencies are Moody’s, Fitch, and Standard and Poor’s. [7]
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    Hold the salesperson to their word—or skip them altogether. Variable annuities are among the most poorly understood retirement vehicles by most consumers, and financial salespeople take advantage of it. Since annuities are usually purchased through a commissioned broker, make sure you treat the transaction with the same level of caution as you would when buying a car.[8]
    • An easy way to caution against misleading claims by the broker is to keep a running list of each claim (rates of return, safety of investment, etc.) and present it to the broker after their pitch. Ask them to sign it. It will cause them to hedge against wild claims.
    • You should also ask the broker (or several of them) about products from different insurers, how they compare to one another, and if they are compensated more or less aggressively by each insurer.
    • Although they may charge higher up-front fees, working with a fee based Certified Financial Planner (CFP) can be a better option than a brokerage. That way you know you’re getting unbiased advice. Not all CFPs are compensated through fees; a portion earn commissions, but they are obligated to disclose the method of compensation. In contrast, all brokers are paid via commission.
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    Find out which mutual funds are available within the annuity. You want to look at the performance of the funds contained within the annuity. Most variable annuities will have several you can choose from, all detailed within the prospectus, but you need to research each one carefully.[9]
    • Don’t forget to factor in the fees along with the return. The higher the subaccount fees, the less you make on the annuity. They can vary considerably—Morgan Stanley quotes prices from .28% to 3.26%, which is more than a 1000% difference in price. And that doesn’t even take into account the other fees.[10]
    • For comparison’s sake, the Vanguard 500 Index Fund (a type of mutual fund pegged to the Blue Chip stock indices), has made 3.84% over the past year, with none of the restrictions a variable annuity would have. Although some mutual funds have made more, others have made far less.[11]

Part 3
Considering Other Options

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    Investigate index funds. An index fund is a type of mutual fund which is pegged to a stock index rather than actively managed. A stock index, such as the S&P 500, is a collection of stocks that theoretically represent the stock market as a whole. So if the S&P goes up in value, the stock market as a whole should go up in value. That means an index fund’s principal investment is distributed among various companies representing the index.[12]
    • Index funds have historically performed well—on average, better than managed funds—and are therefore a good long-term investment tool. [13] While they don’t provide the guarantees of a variable annuity (a guaranteed payout, not a guaranteed amount), they also avoid the fees. The Vanguard 500, for example, charges .05% per year.
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    Think about other types of annuities. If you’re drawn to the guaranteed payout of an annuity, consider index annuities and fixed payout annuities as well. An index annuity is an annuity that is pegged to a stock index rather than managed, just like an index fund. Although you will still have to pay fees for early withdrawals, mortality, and administration, you do avoid larger subaccount fees.[14]
    • A fixed payout annuity is an annuity offering a guaranteed rate of return. They don’t vary according to the market, like a variable annuity. They can be purchased in a lump sum or paid into gradually while the owner of the annuity is working. While there aren’t the same subaccount charges with a fixed annuity as there are with a variable annuity, they still come with the same other fees and restrictions.
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    Look at CDs and money market accounts. If security is what you’re after, then consider money market accounts and CDs. Both offer rates of return slightly higher than a savings account.
    • Rates of return on CDs are usually smaller, but they are insured by the FDIC. Money market accounts aren’t insured, but they do offer slightly higher rates of return.
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    Maximize other retirement programs first. These include 401(k)s, IRAs and Roth IRAs all offer more attractive terms than annuities. A 401(k)’s contributions are matched by employers, IRAs offer more versatility, and Roth IRAs are more versatile and offer tax free withdrawals.[15]

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Categories: Retirement