Certified financial planner Wes Moss provides personal finance advice and accessible investment strategies. His guest post appears here weekly.
I’m constantly asked, “What about a variable annuity? I buy it and it guarantees me a steady stream of income in retirement, right?”
Yes, I am an advocate of investments that will pay you consistently once your working days are done. But I’m not convinced a variable annuity is the best tool for that job.
An annuity is a product sold by insurance companies designed to invest money from an individual and then pay out a stream of income to that investor over multiple years. A variable annuity promises a minimum return from an “income perspective” plus the possibility of a larger income stream based on how well the annuity’s investments do over time.
Understand the following before buying a variable annuity:
“Real vs. theoretical.” Most variable annuities consist of two pools of money – one “real” and one “theoretical.” The real pool is what you place in mutual funds (called sub-accounts) within the variable annuity. You can withdraw this entire pool of money at any time – minus, often times, a surrender charge. The theoretical pool is your initial investment amount that grows at a predetermined rate set by the insurance company – for many annuities that rate is 5 percent per year. But here’s the catch…you don’t have full access to the theoretical bucket. The theoretical bucket is there for you to take an income stream from in the future.
Who’s backing these rates? Annuities are not insured by the government.
Surrender charges. Annuity surrender charges can be significant – often between 2 and 10 percent — and can be imposed as long as 10 years after purchase.
Brutal fees and commissions. The annual non-sales fees average 3 to 3.5 percent. Sales commissions can range from 4 to 8 percent — a significant incentive for those selling annuities.
Getting back your own money? Be wary of annuities that promise things like “guaranteed five percent income.” Annuities with long surrender periods and/or high annual fees lock-up your money and then slowly pay it back to you. Instead, you could receive a 5 percent income stream each year by simply withdrawing your own money for 20 years before it would run out, even if your money earned a zero percent return.
Stampede. What would happen if the Baby Boomer generation needed to “collect” on the “theoretical bucket” guarantee all at once — for example, if the market did poorly over the next 10 to 20 years? How would the annuity companies handle this stampede of Baby Boomers that need to “collect” around the same time? Remember AIG?
The benefits of a variable annuity generally don’t justify the high annual fees and surrender penalties, but they might make sense for some people. For example, if you’re panic-prone, they might help you avoid making bad investment timing decisions.
What’s your take?
– By Wes Moss, for Atlanta Bargain Hunter