In this, the third and final article in this series on annuities, I am going to look at variable annuities.

Although sales of fixed index annuities have recently outpaced variable annuities, they remain very popular among new annuity purchasers.

Also, since you may be pitched one by your friendly insurance rep or financial advisor, I think it makes sense to take a closer look.

What is a variable annuity?

Like fixed index annuities, variable annuities can be confoundedly complex. One reason is that they are an “investment hotdog in an insurance bun.” Consequently, they have the characteristics of both— an investment portfolio and an insurance annuity contract.

One way to look at them is to compare them with their fixed index cousins.

The performance of a fixed index annuity is tied to changes in the price of a stock market index (subject to certain minimums and maximums). But that of variable annuities is based on a set of underlying securities that you directly invest in (such as stock or bond mutual funds—known as “subaccounts”). How those investment assets perform directly determines how well your annuity does, but may also be limited by certain contract provisions.

Like fixed index annuities, variable annuities are intended to be set up as “deferred” payment annuities. During the accumulation phase, your principal grows based on how your investments do, which will determine what your payouts will be during the distribution phase.

You could purchase a variable annuity with a lump-sum or with many smaller payments over time. That money is then invested in those underlying “subaccounts,” which are the investment options you’ve chosen from those made available to you by the insurance company.

These investment choices can range from shares in a single mutual fund, multiple funds, or a “fund of funds.” They can hold equities, bonds, or both. The funds and can be actively-managed funds, or index funds, or both—domestic and international.

Because these are the same types of investments people hold in their Individual Retirement Accounts (IRAs), variable annuities are sometimes recommended for your IRA. However, as we saw in a previous article, that doesn’t make much sense since you would be putting a tax-deferred insurance product into a tax-deferred retirement account. That would be like putting a hotdog in a bun, and then putting the bun in another bun (like what Taco Bell famously does: putting a taco shell inside a flour tortilla to create a new product. By the way, I have never tried it.)

Some of the insurance components of variable annuities come in the form of “riders” (extra cost policy options). These are the guarantees that retirees find particularly attractive that are not available with basic mutual fund investments. They include things like principal protection, lifetime income, and death benefits.

What about returns?

The returns of variable annuities are very unpredictable since they are based on the performance of the underlying investment subaccounts. However, they will never be less than the minimums that are in your annuity contract.

However, like fixed index annuities, calculating your returns is where things get a lot more complicated.

Variable annuities have limits on their upside potential. Although your investments are in a set of mutual funds, the growth of your principal will be based on complex performance calculations used by the insurer to determine what your actual earnings will be.

If you think about it, these earnings limitations are understandable. The insurance company has to limit your performance; otherwise, they wouldn’t be able to take on the risk of poor performance. Nor would they be able to offer the level of downside protection they can at the cost they do.

Due to the dependence on subaccount performance, the contract value of a variable annuity will fluctuate during the accumulation phase. So the payout amounts may vary during the distribution phase as well based on how the underlying portfolio continues to perform. (The exception would be in the case of “annuitization,” which we will look at in a moment.)

A significant implication is that the performance of the underlying investments must be good enough to offset the limitations and embedded costs. Otherwise, you will end up no better off than you would have with a basic fixed annuity of some kind.

Taking income from a variable annuity

When you reach the distribution phase, which could be at retirement age or beyond, you can start receiving annuity payouts. Assuming you are not subject to any contractual surrender charges, which is usually after five to ten years, you can begin taking withdrawals without penalty.

Some variable annuity contracts offer only fixed-income payouts. Others allow for variable payouts or both. In any case, you can (hopefully) continue to build your annuity assets by staying invested in the mutual fund subaccounts.

You can also manage risk by choosing a guaranteed rate of return or income riders (at an additional cost, of course) for at least some of their income payments. For example, if you need at least a 5% payout, you might elect to ensure some portion of it by purchasing the appropriate riders.

Another option is to fully annuitize the principal. That means that you take it as a lump sum and then use it to purchase an immediate fixed income annuity. The insurance company then returns it to you in the form of a series of periodic payments for a guaranteed period (e.g., 5, 10, or 20 years; or for life—a “lifetime immediate fixed income annuity”).

The ability to annuitize is sometimes used as a selling feature of variable annuities. However, in reality, any lump sum of money can be converted into an immediate annuity. You can take money out of a traditional or Roth IRA and purchase an immediate annuity at any time.

What do they cost?

One of the major issues with both fixed index and variable annuities is cost. It’s no secret that the insurance companies don’t give away anything for free, nor should they. They are entitled to make a profit, just like all other companies.

The real issue is transparency (understanding what these products truly cost), and whether the benefits are worth the cost.

As I previously noted, some of the “cost” is embedded in the performance limits imposed by the crediting calculations used by the insurance company. This mechanism ensures that they get their slice of the investment pie, which has to be enough to cover its contractual obligations and expenses and make a profit for their shareholders.

Other costs, which are usually specified in the annuity contract, include ongoing management fees, fees for the underlying investment fund accounts, surrender fees, and fees for options like guaranteed lifetime income protection riders or death benefits. These fees can quickly add up to 2 to 3% or more; which is very high and tends to take away from the upside growth potential.

Should I (or you) purchase a variable annuity?

A deferred-income annuity—whether the fixed index or variable variety—doesn’t seem to make much sense for someone like myself who is already retired. Nor do I think it makes sense to purchase one inside an IRA either.

That said, it may be appropriate for the small number of people who are maxing out their retirement accounts and want to save even more in a non-qualified tax-deferred account (meaning that they fund it with after-tax dollars and only the earnings are taxable as ordinary income).

There may also be some tax and estate-related (wealth transfer) benefits to extremely wealthy retirees.

However, for most of us, they don’t make much sense. Here are some of the other reasons why I have to pass on a variable annuity:

First, I’m not too fond of their complexity. It makes them very hard to understand and difficult to compare with each other and other annuity products. You’d be surprised (maybe not) to hear about the number of people I have talked to who didn’t really understand what they had purchased. (I once worked with one couple who, after realizing what they had bought, paid the surrender charge to get out of the contract and invested in a simple portfolio of low-cost index funds. I didn’t recommend that—they came to it on their own.)

Second, if I move money from my tax-deferred IRA account to a tax-deferred variable annuity, I am putting tax-deferred money into a tax-deferred account, which doesn’t make sense, at least not in terms of the tax-deferral benefits. (That said, there may be certain tax benefits with variable annuities that are not available with IRAs, mainly in estate planning, as unlike an IRA, it can pass to a beneficiary outside of probate. However, this only happens if you have a death benefit provision in place, which usually comes in the form of an optional rider.)

Third, unlike immediate annuities, there is an upside which is provided by the underlying investment funds. However, your fund choices are limited to those offered by the insurer. (But to be fair, the funds are sometimes very good ones that aren’t available to the general public.) I prefer the flexiblity to invest in almost anything through my IRA brokerage account.

Plus, the value of your principal can rise and fall with the stock markets, and it could, theoretically, even go to zero. This is no different than what could happen when investing in a 401(k) or IRA with a traditional stock and bond fund portfolio.

Fourth, although you can purchase a guaranteed income rider to ensure you would continue to receive income even if your principal does go to zero, it comes at a cost, which is usually in the 1% to 1.5% range. Add in the other expenses, and you could quickly get to 3% or even more, not to mention the high sales commissions that are paid for these products.

Fifth, a drawback of most income riders is that they do not necessarily protect against inflation. Moreover, the guaranteed interest that they pay, which is separate from any stock market gains, is consistent with what you could earn for yourself by investing in safe, long-term corporate or government treasury bonds.

If not an annuity, then what?

This brings us back to where we started. At this point in my life, if I were to purchase an annuity, it would probably be a low cost, immediate, inflation-adjusted, fixed-income annuity with a survivor benefit. I would use it to secure a “floor” of guaranteed income to make up the difference between what we receive from Social Security and our essential living expenses. My plan is to consider this again when I am about age 70 and before I am subject to Required Minimum Distributions (RMDs) from my IRA.

For the rest of our retirement income, I will continue to rely on a relatively safe withdrawal rate from my income-oriented stock and bond portfolio and a cash reserve. I realize I am taking some risk, but since my focus is on income (in the form of stock dividends and bond interest), and I maintain a cash reserve, I am not overly concerned with the day-to-day ups and downs of the markets.

Of course, a prolonged market crash would be very damaging to almost any risk-based portfolio, and that is where Social Security and a fixed income annuity come in.

In lieu of a traditional stock/bond portfolio, I could also consider things like a CD or bond ladder, or a TIPs ladder. These options provide income plus a higher level of asset protection.

There is another option that I haven’t discussed. It was suggested to me by a reader (via email). It involves using dividends from paid-up whole life insurance to fund retirement. It is discussed in depth in a book by R. Nelson Nash titled Becoming Your Own Banker as part of a broader financial life strategy of self-funding through policy equity accumulation and borrowing—hence the “be your own banker” concept. I have not read the book, but I am looking into it. If I do, I will comment on it in a future post. I can say now, however, that I would probably view this as a way to supplement the income from savings (IRA, 401(k), etc.), not as a replacement for it.

One more thing

There is one other reason for considering an annuity at some point which I haven’t touched on. It’s the ability to put a portion of our retirement income on “autopilot.” This becomes more important as we age and especially if we suffer from any form of cognitive decline in the future.

I plan to discuss this difficult subject in my next article.