By Ryan Yaffa

What is a variable annuity anyways? A variable annuity is a contract between an investor and an insurance company, under which the insurer agrees to make periodic payments to the investor, either immediately or at some specified point in the future. An investor purchases an annuity contract either by making a single sum payment or a series of periodic payments.

Generally, annuities are structured as either fixed or variable. Fixed Annuities provide fixed payments to the owner over time. Conversely, Variable Annuities allow the investor to receive higher future cash flows contingent on the performance of the investments that comprise the annuity. While Variable Annuities come with more risk, the products can potentially allow the annuitant to reap high returns. A Variable Annuity offers a wide range of investment options such as mutual funds, bonds, stocks, and money market instruments.

Before deciding to purchase an annuity there are important considerations for potential annuitants. First, annuities are illiquid. Deposits into annuity contracts are typically locked up for a period of time, and cannot be recovered by the owner. This period is generally called the surrender period. During this time, if the owner wants to withdraw any of the money, they will be subject to a surrender charge, where the penalties can be steep. Surrender periods can last anywhere from two to ten years and the penalties can be as high as 10%. These charges will reduce the value of the account, as well as the return on your investment. Annuitants can however, add features such as riders to the annuity contract at an extra cost, that will allow them to function as fixed-variable annuities.

Who Should Buy Annuities?

Generally, annuities are most suitable for individuals seeking stable, assured, retirement income. For most individuals, it makes more sense to invest their savings into retirement accounts, such as a 401k or IRA.  Such products are not recommended for younger individuals, especially because of the illiquidity issues and the associated withdrawal fees. It is important to note that the intended purpose of such contracts is not to cash out the annuity for a profit at a later date. The purchaser is merely trading a liquid lump sum in exchange for a guaranteed series of cash flows.

Takeaways

Variable Annuities are complex and offer a variety of features, which can be confusing for potential investors. Thus, it’s imperative that investors make sure they fully understand the terms associated with the annuity before purchasing. That is why potential annuitants should carefully read the prospectus and have their broker explain all of the terms.

While variable annuities can be a great investment instrument under the correct circumstances, there are drawbacks associated. As with all investments, be sure to do your homework, because SURRENDERING is always expensive.