Unlike their deferred annuity counterparts, variable annuities don’t have a locked in rate of return but instead give you a way to ride the market when times are good. The way it works is that the annuity performance is tied to some kind of investment security like stocks, bonds, or money market accounts very much like mutual funds do. When these investments go up you make money and when they go down you lose money.
Your investment starts when you first start your annuity contributions, and when you do you choose what type of investment that you want these contributions to go toward. You could alternatively invest a percentage in each investment option. Depending on what annuity company you are doing business with you will have different options, but remember annuity fees will apply for each of these investments as well.
Pros and Cons of Variable Annuities
The obvious benefit of investing in a variable annuity instead of fixed income annuities is that you can benefit from the upswings in the market. Often times guaranteed rates of return will be much lower than average investments so it can be frustrating to lose out on potential income.
You may be asking yourself why you should invest in a variable annuity rather than just investing in a mutual fund? The answer revolves around the tax benefits that annuities receive. Much like 401K’s and IRA’s annuities are tax deferred on the income portion of the investment (the money you invest is not taxed upon withdrawal), so if you were to invest in a mutual fund instead you would lose out on this benefit.
For those of you worried about losing money, some annuity companies provide a guaranteed minimum rate of return on your investment. Typically this rate of return will be lower than a fixed annuity with the same company but it’s nice to have a floor. Not all companies will provide this option though so you should be sure you are familiar with the terms before investing.
One of the cons of variable annuities are the fees that are charged. Typically annuity fees are higher than other types of investments so you want to make sure the rate of return you are getting is not diluted by these fees.
Lastly, the obvious con is that you can lose money in a market downturn. Just like stocks, bonds and mutual funds, variable annuities can and do lose money so never invest more than you can afford to lose. If you are risk averse a guaranteed annuity may be a better fit for your portfolio.