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Make Sense of Variable Annuities

Understand How Variable Annuities Work Before You Invest

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Variable annuities are a type of retirement investment. They are sometimes offered within employee deferred compensation plans, or sold through insurance agents or brokers. Unlike fixed annuities or indexed annuities, variable annuities are overseen by the Securities and Exchange Commission. I turned to the SEC to see what it has to say about variable annuities.

A Simple Look at Complex Investments

A variable annuity is kind of like a hybrid of an investment and an insurance policy. You enter into this contract by putting money in. You can put a big chunk in all at once or make regular contributions. This money is invested in mutual fund like instruments, holding stocks, bonds, money markets, etc. There are usually a range of investment options. The investments grow tax-deferred, which means you don't pay taxes on the earnings until the money is distributed.

Sounds like other retirement plan options, and it kind of is. But the difference is a variable annuity will make payments to you at some future date. You may get annual payments for 20 years, or for the rest of your life. You may also get a death benefit, that passes these payments or a lump sum on to a spouse or other beneficiary for some period of time.

The time during which you are contributing money is known as the accumulation phase, until you reach the payout phase. Some variable annuities ask that investors remain in the annuity for long periods of time, throughout the accumulation phase, or else pay what is known as a surrender charge. I've heard anecdotally of surrender charges anywhere from 7 percent to 20 percent. And this does not include the additional early withdrawal penalty of 10 percent that you might face if you take your money out before age 59 1/2.

In the payout phase you can choose whether you want to receive fixed or variable payments. The amount of these payments does depend on the performance of the market. Although some variable annuities let you purchase guaranteed minimum income riders at an extra cost.

Variable annuities also have death benefits that pay out a certain amount to your beneficiary after you die. This could be a guaranteed minimum amount you agreed to when you entered into the annuity, or it could be whatever the balance is in your account.

Variable Annuity Fees

The other big difference between variable annuities and other types of retirement investments is the fees. If you do not pay attention, you could wind up paying far too much for the benefits of the annuity.

The SEC outlines several types of fees you pay with a variable annuity:


  • surrender charge - As I discussed above, this is a fee that you may have to pay to withdraw your money from the fund in under anywhere from six to 10 years. A surrender charge is actually a going-away commission for your broker, and while they tend to go down over time, they are usually to steep to be justified.
  • mortality and expense risk charge - Charged as a percentage of the account balance, this is how you pay the insurance company for the risk it assumes taking you on. This could be about 1.25 percent, according to the SEC.
  • administrative fees - Part of any investment, administrative fees include the cost of maintaining the fund, keeping records, mailing, etc. It's about 0.15 percent.
  • underlying expenses - You pay a portion of the costs of the underlying mutual fund investment.
  • fees and charges for other features - This is for guaranteed benefits riders that you may add to your annuity, such as guaranteed income, a stepped-up death benefit, or even long-term care insurance. These benefits come at a higher cost.

These fees can add up, but you can reduce them by looking for annuities sold without commissions or excessive fees. Direct-sold annuities can be found through firms such as Vanguard, Fidelity, T. Rowe Price and Schwab.

There is no easy way to determine whether an annuity is right for you, but a professional financial advisor or tax advisor can help. It's always in your best interest as a consumer to find a fee-based professional who earns no commissions on the investments he or she recommends. If you are considering an annuity, ask every question you can think of. Make sure you understand every fee, the surrender charge time period, death benefits, added guarantees, and what happens if you want to trade your policy for another at a later date.

Next: Questions the SEC recommends asking before you buy an annuity.

The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.

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