Ask Money

Variable annuity

Chris Farrell Jul 16, 2009

Question: Hi, I know from searching Chris’ articles in the past that he’s said variable annuities are a bad idea. I recently found out that my dad is 20 years into a variable life annuity. My dad is retired, living off of social security and savings. Should he keep paying into his VLA at this point? I think he only has a few years left before payout. Or is a VLA so bad that he should just get out now? Thanks for your help! Bonnie, Fremont, CA

Answer: No, unless there is some other problem that isn’t in your note I would not get out of the variable annuity. You dad has saved for more than two decades and he’s about to enjoy the benefits of that savings in retirement. That’s good, and he should enjoy the income. .

A variable annuity is essentially a mutual fund wrapped in a tax-deferred insurance firm account. You buy variable annuities with after-tax dollars, but earnings compound tax-deferred until retirement, when any gains are taxed as ordinary income. Variable annuities come with a death benefit. It’s part of their appeal. When the owner of an annuity dies, the estate or beneficiary gets back the original investment, plus some guaranteed minimum return.

A variable annuity can be a good niche product, especially for those with lots of savings. For instance, Henry “Bud” Hebeler of says he bought low-cost very simple variable annuities for his children. He had maxxed out on other tax-deferred alternatives and he wanted another place to save tax deferred.

My problem with variable annuities comes when it is sold as a primary retirement savings vehicle, especially to younger and middle-aged folks. In too many cases the product comes with a number of drawbacks, including steep fees and limited financial flexibility. Most studies I have looked at emphasize that stocks are probably the best investment for a variable annuity. The fees eat up too much of the return on cash and bonds. The savings are taxed at ordinary income tax rates at withdrawal.

Many financial planners suggest consumers would be better off investing for retirement in a 401(k) and a Roth IRA. I agree wholeheartedly.

I would also consider putting any leftover cash into a broad-based equity index mutual fund. For one thing, withdrawals from a variable annuity are treated as ordinary income, while some of any returns from the mutual fund may be taxed at the lower capital-gains rate. For another, it’s a good idea to have some long-term savings in taxable accounts that can be tapped with paying a penalty to the government or a financial institution. Several years ago, Ross Levin, president of Accredited Investors, an Edina (Minn.) financial-planning firm, told me that they “are the fifth-best option for retirement planning, behind everything else.” That seems about right to me.

The variable annuity market has improved, however. The competition for customers has increased and that means consumers can get a better deal on fees, surrender charges and the like. So, if your financial circumstances say that a variable annuity makes sense, it pays to shop around. Keep the product simple. Avoid the bells and whistles. They’re too expensive.

But for your dad, he should take advantage of the additional income in his Golden Years.

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