2-Minute Money Manager: Should I Get a Variable Annuity?

2-Minute Money Manager: Should I Get a Variable Annuity?
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Welcome to the “2-Minute Money Manager,” a short video feature answering money questions submitted by readers and viewers.

Today’s question is about variable annuities; specifically, whether they’re the right choice for those on the cusp of retirement.

Watch the following video, and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript and find out what I said.

You also can learn how to send in a question of your own below.

For more information, check out “11 Pointers to Investing in Your 60s and Beyond” and “8 Surprising Things Nobody Tells You About Retirement.” You can also go to the search at the top of this page, put in the word “annuity” and find plenty of information on just about everything relating to this topic.

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Got a question of your own to ask? Scroll down past the transcript.

Don’t want to watch? Here’s what I said in the video

Hello, and welcome to your “2-Minute Money Manager.” I’m your host, Stacy Johnson, and this answer is brought to you by MoneyTalksNews.com, serving up the best in personal finance news and advice since 1991.

Today’s question comes to us from Suzanne:

Stacy, we constantly hear that there’s a stock market crash coming. I’m retirement age now. Please give me some insight into Vanguard’s variable annuity. Would this be safer than a 500 index or bond index fund?

Let’s start by defining a variable annuity, then we’ll talk about their advantages and disadvantages.

What’s a variable annuity?

A variable annuity is basically a mutual fund that comes from an insurance company rather than an investment company. A mutual fund is a collection of stocks, bonds or both, divided into shares.

Why do you invest in a mutual fund? Because owning a piece of a diversified portfolio is safer than owning individual stocks or bonds.

Now, back to variable annuities: Why do we want a mutual fund from an insurance company? Because insurance companies offer features typical investment sources can’t.

Variable annuities offer tax deferral, which means as long as you leave your money in the investment account, you don’t pay taxes on the profits. As with an IRA or 401(k), the idea is to let your money accumulate, then take it out when you’re retired and presumably in a lower tax bracket.

Also, like a retirement account, annuities allow you to name a beneficiary upfront. So, should you die, your money passes directly to your beneficiary without having to go through probate.

Variable annuities are not the only type — there are also fixed and immediate annuities.

Advantages of variable annuities

I just told you about a couple of annuity advantages: tax deferral and bypassing probate. But there’s more.

Some variable annuities offer a guaranteed death benefit. For example, say you invest $100,000, the stock market tanks and the value of your account plummets. If you die, however, your beneficiary can’t receive less than the $100,000 you originally invested.

There’s a newer version of variable annuities that goes even further, with a feature called a “guaranteed minimum income benefit,” or GMIB.

This is kind of like the death benefit I just described, but instead of kicking in when you die, it kicks in while you’re still alive; specifically, when retirement time rolls around and you convert your account from a lump sum into a monthly income stream. This is called “annuitization.”

As the name implies, a guaranteed minimum income benefit means your monthly payments will be guaranteed. In other words, if your account goes up in value, your monthly income will be based on that amount. But if it goes down in value, your monthly payments will instead be based on the amount you invested, rather than the current value.

There are also variations. For example, your income may be based on a minimum of 6 percent annual growth, regardless of the actual performance of the account. Or, it may be based on the highest amount the account ever reached.

In short, a guaranteed minimum income benefit offers the upside opportunity of stocks or bonds without the potential downside. If your account increases in value, you’ll have a higher monthly income when you annuitize. But if it goes down, your monthly income won’t suffer.

Different annuity providers may call the GMIB by different names, such as “guaranteed retirement income program” (GRIP) or “guaranteed interest account” (GIA).

Now that we know all that, let’s revisit Suzanne’s question. She asks, “Would this be safer than a regular mutual fund, a 500 index or a bond index fund?” Having the guaranteed income benefit would suggest a variable annuity could indeed be safer.

Unfortunately, however, there’s no free lunch.

The disadvantages of variable annuities

The chief disadvantage of variable annuities is high fees.

Even your garden-variety variable annuity can have management fees of 2 percent annually. By contrast, Vanguard’s 500 index fund charges 0.04 percent. So, the fees for variable annuities are much, much higher.

And that’s just the management fee. Remember that death benefit I mentioned? Another fee. And the guaranteed income benefit? Another fee. So, the fees can be really high on variable annuities, especially relative to regular mutual funds.

Variable annuities can also have big surrender penalties that last a long time. For example, it’s common to have surrender penalties for the first five years, even 10 years in some cases. Also, as with an IRA or other retirement account, withdrawals before the age of 59 ½ are taxed and can be subject to a 10 percent IRS penalty.

Should Suzanne bite?

If Suzanne is saving for retirement, is risk averse and is planning on turning her investment into an income stream in the future, a variable annuity with guaranteed income benefit might work for her, provided she understands the fees and restrictions.

She specifically mentions the Vanguard variable annuity, and that’s a good choice. Vanguard is a low-cost provider, they have people you can talk to, and unlike many other investment houses, their people don’t work on commission.

Which leads me to my last suggestion: No matter who you go to, I’m begging you: If you’re going to buy an insurance product, please avoid commissioned sales people.

I’m not suggesting all commissioned sales people are crooks, but high fees often follow commissions. So, it will pay you to avoid commissioned people when seeking investment products.

Suzanne, I hope that helps you — and I also hope you’ll all meet me right here next time!

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The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

About me

I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.

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