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Pros and Cons of Variable Annuities

Within the financial community, the mere mention of “variable annuities” launches a heated debate over their value as an investment vehicle. Over the last several decades, variable annuities have ridden a roller coaster of controversy and popularity leaving divided opinion in its wake. About the only thing that one could conclude from this is that variable annuities are bipolar in terms of their pros and cons with the final determinant being an individual’s specific financial circumstances.

The pros and cons of variable annuities really must be considered in the context of an individual’s financial profile as they will nicely conform to the investment needs of one person while they may completely run counter to those of another person. This feature-by-feature evaluation of variable annuities can be applied individually to determine their pros and cons for your particular circumstances.

Variable Annuity Feature Evaluation

Professionally Managed Separate Accounts

Much like their investment cousins, mutual funds, variable include a family of professionally managed funds, called separate accounts. These accounts enable investors to direct their funds to any combination of stock, bond, real estate or fixed yield portfolios. Investors can create a portfolio mix that suits their investment needs, and funds can be transferred between accounts several times a year. Variable annuities are protected and regulated by various state and federal agencies, like the SEC and NAIC.

Pros:

Professionally managed; selection of portfolios from different asset classes for balance and diversification; easy transfer between funds; some variable annuity accounts are mirror images of top mutual fund families

Cons:

Narrow selection of funds with some variable annuities; variable annuity account performance is not reported as are mutual funds; turnover of account managers is a little higher than of mutual fund managers

Upside Investment Potential

With the ability to invest in stock, bonds and real estate, investors have the potential to generate higher returns on their annuity funds. Over time, a combined investment portfolio of these three assets classes have performed well and the long term trend continues upward.

Pros:

Unlimited upside potential: Can tap into the potential of different asset classes to take advantage of changing market cycles.

Cons:

Some managed accounts, such as stock, bond and even real estate funds are subject to market fluctuations, and, therefore, market risk. While investors can only incur a loss if they actually sell the units of their account, they still might have to endure periods of time when their account values are below the principle amount.

Annuities Taxation

Considered to be one of the top benefits of owning an annuity, the tax deferral on earnings can make variable annuities look especially attractive, especially for investors in the higher combined federal and state income tax brackets. Transferring funds between accounts does not result in taxes either. The earnings are eventually taxed, when they are withdrawn, as ordinary income. Also, annuity death benefit proceeds are taxed when received, as ordinary income in addition to being includable in the estate.

Pros:

Tax deferral allows for faster accumulation; if a variable annuity is annuitized for periodic payments, the tax deferral is extended as taxes are only paid on the earnings portion of the monthly payment.

Cons:

Earnings are eventually taxed as ordinary income as opposed to the more favorable capital gains tax rate of mutual funds, although mutual fund owners pay taxes each year on gains and dividends that occur inside the fund; Double whammy of ordinary income taxes due on death proceeds and their inclusion in the estate tax calculation. Additionally, annuities death proceeds do not receive a favorable step-up basis calculation for determining the estate tax.

No Maximum Investment

Unlike IRAs or other qualified retirement plans, variable annuities have no upper limit for contributions.

Pros:

Investors who seek maximum tax deferral on their assets can invest as much as they want.

Cons:

Over investment with anyone investment type, or particular annuity product. This can be remedied by spreading investment funds among several different annuity products.

Account Access

As with all annuities, variable annuities allow for investors to withdraw a portion of their funds without charge. Withdrawals of up to 10% of the account value can be made in any one year. Excess withdrawals made within the surrender period will be charged a fee which can be as high as 12% in the first year. The fee is reduced by a point each year of the surrender period until it vanishes.

Pros:

Provides liquidity and some flexibility for current finance needs;

Cons:

Surrender fees can take a significant bite out of annuity funds; Withdrawals made prior to the age of 59 ½ may be subject to a 10% IRS penalty.

Guaranteed Lifetime Income

Variable annuities can be annuitized for income at anytime at which point the annuitant can receive a monthly payment for a specified period of time, or for life. With variable annuities, the payout amount is tied to the performance of the accounts in which the funds are invested, which creates the potential for income to increase as the markets rise.

Pros:

Investors will receive an income they can’t outlive; Income can potentially increase to fight of inflation.

Cons:

Once an annuity is annuitized, the account balance is irrevocably committed to the life insurer; variable income means that the payout amount can also decrease.

Guaranteed Death Benefit

All annuities include a guaranteed death benefit which entitles the named beneficiary to receive at least the principle amount of the contract. For variable annuity holders, this means that, even if the account values decline below the principle, the beneficiary will still receive the original investment.

Pro:

Investors can protect their financial legacy for their heirs;

Cons:

Some variable annuity contracts will only pay the principle as a death benefit as opposed to the entire account value if it is higher. Many variable annuity contracts include options to insure the entire account balance.

Fees and Expenses

Annuity contracts are known for their fees and expenses for mortality costs and administrative costs. Some are lower than others, but there are costs associated with providing death benefits, and other guarantees. All variable annuity contracts include a management fee which covers the cost of managing the investment accounts. You can usually find a differential I the size of the fee when comparing various variable annuity products.

Pro:

Fees can be offset over time through the deferral of taxes; more and more variable annuity products are lowering their fees and eliminating their sales loads.

Con:

With some fee combinations reaching as high as 2.25%, they can eat into returns over the long run;

Some Other Pros and Cons

Asset Protection:

Depending on your state, annuity investments may be protected under its liability laws. Some states don’t exempt annuities from liabilities, while others protect the full value so long as there is no intent to defraud.

Minimum Required Distributions:

Unlike IRAs and other qualified retirement plans, which require that income distributions commence by the time the investor turns 70½, there are no minimum required distributions on variable annuities.

Probate Avoidance:

Generally, annuities are excluded from probate proceeding upon the death of the annuity owner. The benefit is that the proceeds can pass quickly to heir and not add to the cost of the proceedings.

Summary

Every investor is different, and variable annuities, as with any investment, need to be examined only within the context of the individual investor. Generally, variable annuities should not be considered for people who have not reached a point where they are maximizing their contributions to their qualified retirement plans. Nor should pre-retirees with short time horizons consider them unless they are willing and able to hold them for at least 10 to 15 years. But, for others who can take advantage of the tax deferral and, ultimately, are concerned with outliving their income, variable annuities can be the ideal investment.

How to Allocate Funds Inside a Variable Annuity

Variable annuities combine some of the key features of mutual funds with those of deferred annuities to produce a unique investment vehicle that is ideal for long term retirement planning. Like mutual funds, variable annuities include a family of funds, called separate managed accounts that invest in various portfolios of stocks, bonds, real estate, and fixed yield investments affording investors the opportunity to achieve market-based returns. The primary difference is that the earnings from variable annuity managed accounts are allowed to accumulate tax deferred. Optimizing both the returns and the tax advantages of variable annuities requires a sound asset allocation strategy tailored for each investor.

Variable Annuity Investment Characteristics

A variable annuity is a form of a deferred annuity in which investors are allowed to choose from among a family of professionally managed accounts to invest their funds. Typically, the family of accounts is comprised of a variety of stock and bond accounts with varying investment objectives. For instance, the stock accounts might include a growth stock account, an aggressive growth account, and an international stock account.

The bond accounts might include a corporate bond account, a high yield bond account and a government bond account. You might also find a balanced account that combines stock and bond investments, and accounts that invest in real estate investment trusts are also common. Finally, the family might have a cash account or a fixed yield investment.

Each of these accounts fall within a specific part of the risk/reward spectrum, with some offering potentially high returns with a commensurate level of risk. On the other end are accounts that focus on minimizing risk with lower or more stable returns. As with type of investing, no one single account is going to meet the overall investment objectives of an investor, nor will it likely satisfy his or her risk requirements. Therefore, the best investment approach is to allocate investment funds among several different asset classes, and diversify within those classes in order to create a more stable portfolio with the potential for consistent long term returns.

What is Asset Allocation?

Asset allocation is an investment strategy that considers a combination of asset classes for investors’ portfolios that best match their objectives, preferences and risk tolerance. Since asset classes tend to perform differently, within their own investment cycles, owning several asset classes will have the effect of stabilizing the overall portfolio. For example, when stock prices increase, bond prices tend to decline. Because no one can accurately project the movements of either, the best strategy is to allocate a portion of funds to each.

The more a portfolio consists of assets that don’t necessarily correlate with one another, (in other words, the price movements of one are independent of another), the less volatile the overall portfolio will be. For example, real estate is an asset that doesn’t necessarily correlate with stocks. The prices of real estate tend to move independent of other markets.

Modifying Risk

Additionally, each asset class has a corresponding amount of risk, whether it’s market risk, inflation risk, taxation risk, interest rate risk or liquidity risk. An effective allocation strategy accounts for all forms of risk by using one type of asset to offset the risk associated with another. For instance, an investment in fixed annuities is vulnerable to the long term effects of inflation. By combining that investment with an investment in a precious metals fund or a real estate fund, the potential risk of inflation is countered. Conversely, the fixed yield account can have a modifying effect on any volatility associated with the other funds.

Creating an Individual Asset Allocation Strategy

Using a combination of asset classes, investors can create a total investment portfolio that more closely matches their specific objective, priorities, preferences and risk tolerance. The asset mix of any one investor is going to be different than the next, so there is no one perfect portfolio allocation. Rather, investors need to consider their own allocation in light of their individual financial circumstances:

Goals and Priorities

: Without a clear target, it is difficult to know where to aim. And, because most investors have a limited amount of funds to invest, priorities must be set.

Risk Tolerance

: It’s important to understand your ability to withstand market fluctuations. More importantly, all types of risks need to be considered.

Investment Preferences

: Some investors have an aversion or a preference towards certain types of investments. For instance, some will only invest in the stock socially responsible companies.

Time Frame

: Understanding your investment time frame is important for determining the proper balance of conservative and more growth oriented investments. That balance will change over time as your time frame shortens.

Asset Allocation in Motion

Once you have determined the best allocation for your portfolio, it is vitally important to review it regularly. Your financial circumstances, including your outlook and risk tolerance will evolve over time, and you can count on the fact that the financial markets and the economy will change as well.

A big mistake investors make is to let the gains in any one asset class to run, which will throw their allocation out of balance. For instance, they may have allocated just 40% of their funds to stock accounts. Yet, after a long stock market rally, the gains achieved push that allocation up to 60% of their portfolio. Their portfolio is now exposed to more market risk than, perhaps, they were willing to assume initially.

An asset allocation strategy is definitely not a set-it-and-forget-it strategy. It is important to make sure your portfolio is correctly balanced and properly diversified to match your current financial profile. With variable annuity investors are allowed to transfer funds between accounts as many as four to six times a year, which is plenty to make any necessary adjustments.