A variable annuity is a powerful tool for growing long-term investments, especially during the accumulation period. At Paradigm Life, we focus on maximizing growth through tax-deferred strategies. This guide explores how variable annuities can deliver high returns while aligning with your tax-efficient goals using our Perpetual Wealth Strategy™.
What is a Variable Annuity?
A variable annuity is a long-term investment designed to grow retirement savings with higher return potential. Unlike a fixed annuity with guaranteed rates, a variable annuity’s growth depends on underlying investments like mutual funds—and it may shrink if they perform poorly. It’s ideal for those willing to accept market risk for the chance of greater financial growth.
How Does a Variable Annuity Work?
Understanding how a variable annuity works is essential for informed financial decisions:
- Premium Payments: You make initial or periodic contributions, which grow tax-deferred until withdrawal.
- Investment Options: Funds are allocated to subaccounts, similar to mutual funds, investing in stocks, bonds, or money markets. You customize your portfolio based on risk tolerance and goals.
- Fluctuating Value: The annuity’s value changes with market performance, offering growth potential but also the risk of declines.
While flexible, a variable annuity requires active management and awareness of market conditions.
Benefits of a Variable Annuity
Investing in a variable annuity comes with several advantages:
- Potential for higher returns: Variable annuities, unlike fixed annuities, may earn more. They invest in the market. This can be especially appealing for those planning long-term investments.
- Tax-Deferred growth: One of the standout features of a variable annuity is tax deferral. Your investment gains aren’t taxed until you withdraw funds, which allows your savings to grow more efficiently over time.
- Customizable investment strategy: You can choose from many investments. This lets you tailor your strategy to your goals and risk tolerance.
- Death benefit: Many variable annuities offer a death benefit. It ensures your beneficiaries get a guaranteed amount, even if the account value has decreased.
Risks of a Variable Annuity
While variable annuities offer benefits, it’s important to consider the risks:
- Market Volatility: Poor market performance can reduce your annuity’s value, making it less predictable than a fixed annuity.
- High Fees: Management, mortality, and surrender charges can significantly impact your returns, so understanding the fee structure is essential.
- Complexity: These products require careful planning and monitoring. Consulting a financial advisor ensures they align with your goals and risk tolerance.
Variable annuities suit those seeking tax-deferred growth and willing to accept some risk. Balancing potential rewards with these risks is key to success.
Key Features of Variable Annuities
A variable annuity is packed with features that make it a unique and potentially valuable tool for retirement planning. Let’s dive into the key characteristics that set variable annuities apart and why they might be a great fit for your financial strategy.
Investment Flexibility
One of the standout features of a variable annuity is the wide range of investment options available. When you purchase a variable annuity, you can choose from a variety of subaccounts, which function much like mutual funds. These subaccounts invest in different asset classes, such as:
- Stocks: For higher growth potential, though with greater risk.
- Bonds: To provide more stability and lower risk compared to stocks.
- Money market funds: For low-risk investments with steady returns.
This lets you tailor your strategy to your risk, goals, and time. As market conditions change, you can also adjust your investment allocations to optimize growth or minimize risk. This customizable approach makes variable annuities a great option for long-term investors. They seek to balance risk and reward.
Tax-Deferred Growth
Another major advantage of a variable annuity is its tax-deferred growth. Here’s what that means:
- No immediate taxes: You won’t pay taxes on any investment earnings until you start making withdrawals. This allows your money to grow more efficiently over time because you’re reinvesting what would have otherwise gone to taxes.
- Compounding advantage: With tax-deferred investments, your earnings compound on a larger amount, accelerating growth. This can significantly increase your retirement savings, especially if your investments perform well over a long period.
Tax deferral is a great benefit. It helps those who want to maximize their long-term investments. However, when you withdraw funds, they will be taxed as ordinary income.
Income Options
A variable annuity provides a reliable income stream for retirement, offering flexibility to meet your financial needs. Common options include:
- Lifetime Payments: Guaranteed income for life, ideal if you’re concerned about outliving your savings.
- Fixed-Term Payments: Payments for a set period, like 10 or 20 years, suitable if you have other income sources.
With investment flexibility, tax-deferred growth, and customizable income options, a variable annuity can align with your financial goals. However, balance its potential for higher returns against risks like market volatility and fees before deciding.
Death Benefit and Other Protections in a Variable Annuity
When using a variable annuity in your financial plan, you have to know its protections. They can give you and your loved ones peace of mind. A variable annuity’s value can fluctuate with the market. But, features like the death benefit and optional riders reduce risk and provide a safety net.
Understanding the Death Benefit
A key feature of many variable annuities is the death benefit, which provides financial security for your loved ones if you pass away during the accumulation phase.
- Guaranteed Minimum Payout: Your beneficiaries will receive at least the total amount you contributed (minus withdrawals) or, in some cases, the highest account value reached, even if investments underperform.
- Protection for Loved Ones: This ensures your investment retains value and shields your family from financial hardship, even in a declining market.
What Covers the Cost of a Variable Annuity’s Death Benefit?
A variable annuity’s death benefit is funded through annual mortality and expense risk charges, calculated as a percentage of your account value. These fees compensate the insurer for guaranteeing a minimum payout to beneficiaries.
While the death benefit offers valuable protection, it’s crucial to understand how these charges affect your returns. Ensure the added security aligns with your financial goals to assess if it’s worth the cost.
Additional Riders for Extra Protection
Many variable annuities offer optional riders to enhance benefits, providing flexibility to meet your needs but often at additional costs.
- Guaranteed Lifetime Income Riders: Ensure a steady income for life, even if your account balance is depleted, ideal for retirees seeking stability.
- Enhanced Death Benefit Riders: Offer higher payouts to beneficiaries, often tied to the highest account value or stepped-up amounts, though they increase fees.
- Long-Term Care Riders: Provide extra funds for long-term care, offering financial protection for health-related expenses.
While these features add security, they come with costs. Balancing protection and growth helps create a retirement plan that supports your goals and provides peace of mind.
Regulation and Oversight of Variable Annuities
Investing in a variable annuity means trusting the institutions managing your investments. Fortunately, variable annuities are well-regulated to protect your interests. Understanding who oversees these products helps you invest confidently and grasp how compliance measures ensure security.
Who Regulates Variable Annuities?
A variable annuity is uniquely regulated by two entities for strong investor protections:
- Securities and Exchange Commission (SEC): Oversees the investment component, requiring transparency about risks, fees, and terms through detailed prospectuses. This ensures market-based subaccounts are fully disclosed.
- State Insurance Departments: Regulate the insurance aspects, such as death benefits and income guarantees, ensuring insurers remain financially stable and meet their obligations.
This dual oversight ensures both the investment and insurance features of a variable annuity are well-regulated for your protection.
Compliance and Transparency
Compliance and transparency are key to variable annuities, ensuring investor protection:
- Disclosure Requirements: The SEC mandates that insurers disclose fees, investment options, and risks, giving you the information needed to make informed decisions.
- State Regulations: State insurance departments monitor insurers’ finances to ensure they can meet obligations like paying death benefits or lifetime income.
Understanding these regulations reassures you of a variable annuity’s legitimacy and emphasizes the importance of reviewing documents like the prospectus. This knowledge helps you invest securely.
Fees and Expenses in a Variable Annuity
A variable annuity can grow your retirement savings, but it comes with high and complex fees that can impact your returns over time. Understanding these costs ensures your investment aligns with your financial goals and helps you make informed decisions.
Types of Fees in a Variable Annuity
Variable annuities have fees. They cover insurance, investment management, and admin costs. Here’s a breakdown of the most common ones:
- Mortality and Expense (M&E) risk charges:
- These charges pay the insurance company for the risks they take. These include guaranteeing death benefits or income payouts.
- Typically, M&E fees range from 0.75% to 1.25% of your account value annually.
- Investment management fees:
- These are costs associated with managing the subaccounts within your variable annuity. Because these subaccounts often function like mutual funds, you’ll pay fees similar to mutual fund expense ratios.
- Investment management fees can range from 0.5% to 2% annually. It depends on the complexity and performance of the chosen investments.
- Administrative fees:
- These cover the costs of maintaining your account, such as record-keeping and customer service.
- Some insurance companies charge a flat fee (e.g., $30–$50 per year) or a percentage of your account value.
- Surrender charges:
- If you withdraw funds from your variable annuity within a specified period, usually 6 to 10 years, you may face a surrender charge. This fee often starts high, around 7%, and gradually decreases each year.
- Surrender charges discourage early withdrawals. They help the insurance company recoup its costs.
- Optional rider fees:
- If you add features like a guaranteed lifetime income rider or an enhanced death benefit, you’ll pay extra fees. These can range from 0.25% to 1% of your account value annually.
Impact on Returns
Variable annuity fees can greatly affect your long-term investment returns. Here’s how:
- Erosion of gains: High fees can erode the benefits of tax-deferred growth. Even if your subaccounts perform well, hefty expenses may eat into your profits, reducing the overall growth of your annuity.
- Compounding effect: Because fees are often a percentage of your account value, they compound over time. This means that the longer your investment is held, the more substantial the impact of these fees can be.
If your variable annuity has a 3% annual fee, your investment must grow by at least 3% a year to break even. So, it’s vital to understand and compare fees. Do this when considering a variable annuity for your retirement strategy.
Who Should Consider a Variable Annuity?
Choosing the right investment is crucial for your financial future. A variable annuity can be a great option for some investors. But how do you know if a variable annuity fits your needs? Here’s what to consider.
Investor Profile
A variable annuity suits those who accept some risk. It offers tax-deferred growth. If you can tolerate risk and know the market’s ups and downs, a variable annuity may suit your financial goals. This product is ideal for:
- Investors seeking market-based returns: If you’re willing to ride out market volatility for the chance of earning higher returns, a variable annuity provides multiple investment options. You can allocate your premium payments into subaccounts that invest in stocks, bonds, or a mix of both, similar to mutual funds.
- Those focused on tax efficiency: Because a variable annuity allows your investment earnings to grow tax-deferred, you won’t pay taxes on gains until you make withdrawals. This feature can be especially beneficial if you’re in a high tax bracket now but expect to be in a lower one during retirement.
- Individuals planning for retirement: People who have maxed out other tax-deferred accounts, such as 401(k)s and IRAs, may find a variable annuity a strategic addition to their portfolio. It provides another avenue to save for retirement while delaying taxes on earnings.
If you value diverse strategies and long-term growth, consider a variable annuity. It might be a good fit for you as an investor.
Long-Term Planning
A variable annuity is designed with long-term financial goals in mind. It’s not a short-term investment, so consider this option if you’re looking to build wealth over several decades and use it as a part of your comprehensive retirement plan. Here’s why it’s ideal for long-term planners:
- Retirement income security: Variable annuities can provide a future income stream, either for a fixed period or for the rest of your life, depending on the payout option you choose. This can offer added security when you’re no longer working.
- Diversification: By spreading your investments across different asset classes within a variable annuity, you can reduce risk and increase your chances of achieving your retirement savings goals. It’s a smart way to add variety to your investment portfolio while benefiting from market-based growth.
- Compounding advantage: The longer you let your funds grow in a tax-deferred environment, the more you benefit from compound interest, which can significantly boost your retirement savings.
How Variable Annuities Fit Into a Wealth Strategy
A variable annuity can be a valuable part of a solid wealth plan, balancing risk and security. With market growth potential and protective features like death benefits, it supports both financial growth and stability.
At Paradigm Life, we focus on strategies that align with our Perpetual Wealth Strategy™, combining tax-efficient, long-term growth with security. A variable annuity is ideal for diversifying retirement income while benefiting from tax-deferred investments.
Strategic Considerations
Before adding a variable annuity to your financial toolkit, it’s important to consider its role within your comprehensive strategy. Here’s how to evaluate its fit:
- Hierarchy of Wealth™ Assessment : At Paradigm Life, we use the Hierarchy of Wealth™ framework to prioritize financial decisions. Variable annuities typically fall under Tier 3, which includes growth-focused, market-based assets. While they offer upside potential, they should come after securing foundational investments like cash flow and insurance protection.
- Risk vs. Reward: Variable annuities can be a strategic choice if you’re comfortable with market fluctuations and focused on long-term growth. Tax-deferred earnings can boost your savings, but it’s important to weigh the potential for losses if markets underperform. Balancing these factors helps ensure your investment aligns with your goals.
- Retirement income planning: Variable annuities provide flexible payout options, including lifetime income guarantees. These features can supplement other retirement income sources, offering financial stability and reducing concerns about outliving your savings.
- Estate and legacy planning: With built-in death benefits, variable annuities can leave a financial legacy by guaranteeing a payout to your loved ones, even if investments underperform. This makes them a valuable part of a broader estate plan, combining growth potential with financial protection.
Frequently Asked Questions
Which of the following is true regarding variable annuities?
A variable annuity has investment options that depend on the market. So, the annuitant bears the investment risk. Returns can be high if markets perform well, but there’s also potential for loss if markets decline. A variable annuity, unlike a fixed annuity, does not guarantee a return. So, you must consider your risk tolerance before investing.
Which two entities regulate variable annuities?
Variable annuities are regulated by the SEC and state insurance departments. The SEC oversees the investment aspect, ensuring transparency about fees and risks. State insurance departments regulate insurance features, like death benefits. They ensure companies meet their obligations. This dual regulation ensures comprehensive consumer protection.
What covers the cost of a variable annuity’s death benefit?
The cost of a variable annuity’s death benefit is covered by mortality and expense (M&E) risk charges. These fees pay the insurance company for its guarantees. These include a minimum payout to beneficiaries. M&E charges are a percentage of your account value. They are deducted annually. This can hurt your returns, so consider them carefully.
Optimizing Your Wealth Strategy with Variable Annuities
A variable annuity offers market-driven growth and protection, making it a strong option for long-term retirement planning. Benefits like tax-deferred growth and flexible income options can enhance your wealth strategy, but it’s important to consider risks and fees. At Paradigm Life, our Perpetual Wealth Strategy™ helps you make informed decisions. Connect with a Paradigm Life Wealth Strategist today to see if a variable annuity fits your financial goals and take the next step toward securing your future.
