Variable Annuity Pitfalls
Variable annuities are criticized by some for high management fees, surrender charges, and lack of flexibility. It is true that uninformed investors are easily sold unfavorable contracts, but the same can be said for any product purchased hastily, without comparison shopping. Otherwise, variable annuity fees are comparable to those of mutual funds.
As long as you're investing with the right intentions and proper awareness, you'll be well positioned to shop for a quality variable annuity. The follow is a list of common variable annuity investment pitfalls:
- Don't invest in variable annuities with cash you'll need tomorrow. Early withdrawls fees may apply, and you should be prepared to take losses with a market downturn.
- Diversificaiton: Divide your variable annuity investment across at least 4 sub-accounts.
- Management Fees: Variable annuities can charge an annual 1-2% managment fee, similar to mutual funds.
- Investment Options: Check the variable annuity's prospectus to make sure it offers investment options that interest you.
- Surrender Charges: Don't terminate the annuity contract early. You'll be charged fees and a 10% tax penalty.
- Front-end Load: A small percentage of variable annuities charge upfront commision. Look for "No-load" plans.
Pitfall #1: Investing Short-term
Variable annuities are retirement savings vehicles, meaning they're designed for long term, discretionary investors. The worst possible pitfall when it comes to annuities is investing money you might need to pay next month's rent. This is especially true of variable annuities because unlike their fixed rate counterparts, your principle is not guaranteed. Because variable annuities invest in high-growth equities, you could see losses on down years.
Think of variable annuities as a 401(k), IRA, or mutual fund analogue. All of these instruments have the potential to lose money, but they always come up on top in the very long term — which is exactly what retirement planing calls for. If you're thinking of equity investment, you're looking for higher growth at added risk. And the best way to minimize that risk is with a long term, diversified portfolio. If you keep this in mind, variable annuities will average 10%+ growth throughout the lifetime of your retirement plan.
Young Investors Be Ware
Variable annuity income is subject to a 10% IRS tax penalty when withdrawn prior to the age of 59.5. The IRS imposes this penatly to disincentivize annuity investment for purposes other than retirement savings. The 10% tax penalty makes variable annuities unappealing to young investors hoping to cashout early. For such investors, mutual funds are the best alternative.
Variable Annuity Management Fees
Most variable annuities come with an annual management fee, sometimes called a mortality and expense charge. Although explained in the prospectus, this fee can be hidden from quarterly income statements.
The annual management fees ranges from 0.5%-2%, depending on where you buy your variable annuity. The insurance company charge this fee to pay its own overhead and hire professional money managers to safeguard your portfolio. This fee is subtracted out of your total annuity balance every year, but can never increase throughout the life of the contract.
While management fees are a definite variable annuity disadvantage, they are a factor of variable annuity alternatives as well. If you're considering mutual funds, they come with management fees of the magnitude (0.5%-2%). Apples to apples you can't escape paying your insurer or broker some form of commission. The upside of management fees is that the insurer now has a stake in your portfolio, incentivizing good managment.
Don't Just Shop, Implement a Solid Retirement Strategy
Purchasing an annuity is a big decision. Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities.Speak with an advisor over the phone about annuities for FREE.
The Variable Annuity Prospectus
All variable annuities feature a prospectus — an information packet that outlines types of available investment options, contract fees, and historical performance data. Mutual funds feature similar documents.
It's important that to solicit and carefully examine a prospectus from any potential variable annuity that you're shopping for. The big pitfall here is failing to inspect the types of investment options offered by a particular annuity plan. A major reason for investing in variable annuities in the first place is to manage one's own portfolio. In this case, you want to make sure your variable annuity will have the types of sub-accounts you find appealing. Whether you intend on allocating funds in foreign stocks, high-growth immerging markets, bonds, or the S&P 500, double-check that you'll have that investment option.
It's good idea to think ahead and purchase a variable annuity that features a fixed rate sub-account option. Many variable annuities have a money market sub-account that effectively turns them fixed-rate at any time. By reallocating funds into a money market sub-account, you can guarantee a 1-3% return. This is a great option to have during down markets, when you want to sacrifice growth to minimize losses.
Avoiding Surrender Charges
Insurance companies make money on annuities when investors get shaky and try to cashout early. Most annuities feature withdraw charges that phase out over time. A typical charge might start at 8% and scale back to 0% over a period of 5 years. Obviously you want to avoid paying this charge at all costs. Some variable annuities never phase out to zero percent — those you want to avoid.
The good news about surrender charges is that they're easy avoidable in most cases. Investing discretionary money, in accordance to pitfall #1, will eliminate most needs for early withdraw. If the rare case does arise, like a family emergence or loss of job, the penatly-free withdraw allowance should cover your needs. This up to 10% per year. This provision allows you to withdraw upwards of 10% (depending on your plan) from the annuity every year without incuring a withdraw charge.
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