Understanding Variable Annuities: Growth Potential and Risk

Variable annuities can offer a unique blend of market-driven growth and insurance-backed guarantees. By exploring their structure, benefits, and drawbacks, investors can determine if these contracts align with their retirement goals.

What Is a Variable Annuity?

A variable annuity is essentially a contract between an investor and an insurance company that sets the stage for both saving and income distribution. During the accumulation phase, contributions are invested in a selection of subaccounts, which are typically mutual funds spanning equities, bonds, and balanced portfolios.

Upon reaching the payout phase, also known as annuitization, the contract converts its value into periodic payments. These payments may fluctuate based on investment performance or remain fixed if the investor selects a guaranteed option.

How Variable Annuities Can Grow Your Wealth

Market-linked returns and performance are the primary drivers of growth within a variable annuity. In 2023, for instance, equity subaccounts delivered an average return of 23.59%, surpassing comparable equity mutual funds at 20.79%.

Tax deferral is another compelling advantage: earnings accumulate tax-deferred growth until withdrawal, allowing investors to reinvest what would otherwise have been paid in annual taxes. Over decades, this feature can significantly enhance compounding effects.

Moreover, variable annuities encourage long-term investment horizons and compounding. The structure is designed for retirement planning, which helps investors resist the temptation to react to short-term market volatility.

Investment Options and Diversification

Investors can tailor their portfolios by selecting from multiple subaccounts. Choices often include stock funds, bond funds, and hybrid or balanced funds. Some contracts even provide a fixed account with a guaranteed interest floor.

• Equity subaccounts for growth potential
• Fixed accounts for conservative returns
• Balanced funds for risk-adjusted exposure

This design enables diversification within the annuity, which can mitigate volatility and smooth long-term returns.

Key Risks and Costs to Consider

Despite the growth potential, variable annuities come with complex fee structures and charges that can erode performance. Annual fees often range from 3% to 4%, covering mortality and expense risk charges, administrative fees, and fund management costs.

Optional riders—such as guaranteed minimum income benefits—add further expense. Surrender charges typically apply for early withdrawals during a seven- to ten-year lock-in period. These extended surrender charge periods can significantly reduce liquidity.

Market risk is ever-present: if subaccount investments underperform, investors could face potential for principal loss. Understanding each fee and penalty is crucial before committing capital.

Benefit Features and Riders

Variable annuities often include built-in protections. A standard death benefit guarantees that beneficiaries receive at least the premiums paid, less withdrawals, if the owner dies before payments begin.

For additional protection, investors can purchase riders. These may include living benefits that guarantee a minimum withdrawal amount or lifetime income regardless of market results. While valuable, these riders carry extra fees and should be evaluated carefully.

Pros and Cons at a Glance

Who Should Consider Variable Annuities?

• Investors nearing or in retirement seeking predictable income
• Those desiring optional living benefit riders for added security
• Individuals comfortable with market volatility in exchange for growth

The average variable annuity buyer is around 65 years old, underscoring the product’s suitability for retirement planning. However, these contracts demand a clear understanding of fees, investment options, and potential penalties.

Market Trends and Regulatory Landscape

After a dip in sales during 2023, variable annuities rebounded with $13.7 billion in new contracts in Q1 2024, a 7% year-over-year increase. Demographic shifts, including an aging population, coupled with expectations of declining interest rates, are likely to drive continued growth.

Regulators maintain scrutiny due to the products’ complexity and impact on retirement security. Investors should verify an insurer’s financial strength and review prospectus details carefully.

Conclusion: Making Informed Decisions

Variable annuities offer a compelling mix of market-driven growth potential and insurance guarantees. Yet, the benefits come with significant costs and risks. Prospective buyers must weigh tax advantages, investment flexibility, and riders against fees, surrender charges, and market volatility.

By conducting thorough research, consulting financial professionals, and comparing product features, investors can harness the potential of variable annuities to build a more secure and growth-oriented retirement plan.