Moliciero Financial | Investing and Financial Planning

Pros and Cons of Variable Annuities

A variable annuity is a type of investment contract that is designed to provide tax-deferred income in retirement. Variable annuities can be purchased using either a lump-sum payment or through a series of payments, as into an IRA or retirement savings account. There are options within a variable annuity plan that allow the holder to allocate money into different investment types or sectors of the market. Variable annuities are usually sold through insurance companies, and can be considered a form of retirement insurance.

Variable annuities were introduced by a large teacher’s retirement fund in the early 1950s as a way to fund pension agreements. Prior to their introduction, inflation claimed a large portion of the teachers’ retirement savings because the benefits were made as fixed payments. Since variable annuities paid an amount that was based on market performance, the payments generally kept up with inflation. They gained in popularity among the general public in the 1970s and 1980s, largely due to high rates of inflation that were present during that time.

How Variable Annuities Work

As with other types of annuities, variable annuities have two phases, the accumulation phase and the payout phase. During accumulation, the annuity holder pays into the annuity account, and when a certain milestone is reached – usually retirement age – the payout phase begins. The “variable” in variable annuities, refers to the amount paid to the recipient during the payout phase. With a variable annuity, the amount paid to the holder is based upon the performance of investments made during the accumulation phase of the annuity. This is what keeps inflation from consuming retirement funds in this type of annuity contract.

The investments that are made in a variable annuity account are generally placed into mutual funds. The investments are divided into sub-accounts, with each sub-account holding one fund. The variety and selection of mutual funds that can be invested in is usually large. Depending upon the risk tolerance level of an individual investor, a variable annuity can be structured to range from very conservative bond funds to more risky and higher performing stock funds. Since stocks and mutual funds have been show to grow an average of 14% over time, this can lead to a substantial retirement nest egg.

Advantages of Variable Annuities

As with any investment type, there are advantages and disadvantages to variable annuities. A variable annuity may be the right investment choice for one investor, and inappropriate for another. To understand if this type of retirement investment is right for you, let’s take a look at some of the positive aspects of variable annuities.

We know that variable annuities allow investment in a variety of mutual funds and even ETF funds, through sub-accounts. The fund investments in any of these sub-accounts may be changed or reallocated at any time, usually with little or no cost. This allows the annuity holder substantial control over his market exposure, and the potential of higher investment returns.

Money invested in a variable annuity is tax-free until it is withdrawn. The IRS limits the amount that can be deposited into a 401(k) or IRS account. Since there are no limits to the amount of money that can be deposited in a variable annuity account, this can be a great way to defer taxes on money that is received as a windfall.

Variable annuities offer income for life. This can be a way for an investor to create a secure pension for himself in retirement. Flexible terms are also available for many variable annuities. There are short, medium and long-range terms that can be applied, which may allow an investor quicker access to capital if needed.

Many variable annuity plans offer a life insurance option that allows for a beneficiary to take ownership of the account in the event of the holder’s death. This is a way to avoid probate and even death or estate taxes, since the annuity tax treatment rules still apply.

Disadvantages of Variable Annuities

As mentioned, variable annuities are not the perfect retirement investment for everyone. Factors such as age, income level, tax bracket or other considerations should always be taken into account when planning for retirement. Here are some of the potential drawbacks to variable annuities.

Issuers of variable annuities typically charge higher fees than standard mutual fund management fees. Many variable annuities charge expenses and insurance fees on each sub-account in the annuity. Often, commissions are paid separate from the management fees, adding to the cost.

Early withdrawal and surrender fees are another cost of variable annuities to be aware of. If there is a chance that you may need to retrieve your money from a variable annuity account before the payout phase, this may not be the best retirement choice for you. Although surrender fees disappear, usually after 7 years, early withdrawal penalties apply until age 59 ½.

There is also a potential risk of capital loss with variable annuities. Although not common, the principal amount in a variable annuity can depreciate in value from year to year. While it is unlikely that the entire amount would be lost, an uneducated investor could severely damage his retirement account by making unwise fund selections.


Variable annuities are a highly flexible way to save for retirement and protect wealth for many investors. Having a guaranteed income during retirement is a very attractive option for some. Consider all of the pros and cons when deciding whether this investment choice is right for you.