Variable Annuities: The Do-It-Yourself Pension Plan

By Lisa Smith AAA

For many investors, variable annuities have become the modern-day version of the personal pension plan. While our grandparents could often count on their employers' largess to provide a predictable cash flow for their golden years, our parents weren't always so lucky. Many of them worked a lifetime only to find out that the pension payments they had been counting on to put some gold in their golden years never panned out. Faced with the less-than-sunny outlook for the prospect of a steady stream of income provided by their employer, the sad state of affairs at the Social Security Administration, and the uncertainty of the stock market, many investors are turning to variable annuities as an alternative method of generating predictable, guaranteed retirement income. (The Demise Of The Defined-Benefit Plan and Is Your Defined-Benefit Pension Plan Safe? provides some additional insight into the bleak predictions for the future of employer-provided pensions.)

Build Your Own Pension Plan
Variable annuities can function much like 401(k) plans and other tax-deferred savings programs offered through employers. Investors put away a small amount of money on a regular basis over a long period of time. The money is invested in variable annuity subaccounts, which are essentially clones of mutual funds, where it grows tax-deferred until the investor retires. The subaccounts offer a wide variety of investment choices, including many options that mirror popular mutual funds offered through nationally recognized fund companies. (To learn about these accounts, read Subaccounts: As Good Their Clone Funds?)

If the subaccounts grow in value, the investor benefits. If the investor is concerned about the subaccounts losing value, for an additional fee, variable annuities can offer strong downside protection against stock market declines. The protection, known as a guarantee minimum withdrawal benefit (GMWB), guarantees that the investors will receive a specific payment amount regardless of the value of the underlying portfolio. Some guarantees provide that set payment for life, while others offer it for a set period of time or a set amount. A guaranteed return of 5% per year is not uncommon.

Alternative Perspective
Variable annuities have long been derided by critics who complain about the cost and complexity of these investments. The fees include money paid to the subaccounts for investment management, money paid to the insurance company for the guarantee, and money paid for administration and other expenses. The impact of these fees is a reduction in the return on investment when compared to the mutual funds after which the subaccounts have been cloned. The critics cite the cost and reduced investment returns as the price for purchasing insurance that you don't need. (The Cost Of Variable Annuity Guarantees explains how these products tempt investors with some impressive benefits, but that the benefits come at a price.)

Critics also cite the lack of liquidity that comes with these investments, as there are various stipulations regarding the length of time the money must be invested in order to benefit from the guarantees, restrictions on early withdrawals, etc. (Variable Annuity Benefits: What The Fine Print Won't Tell You provides additional insight into some of the critics concerns.)

New Reality
The bear market of 2008 invalidated most of the criticisms that variable annuities have faced. While many investors lost 40% or more of their retirement nest eggs, variable annuity investors that opted for the guarantees earned exactly what they expected to earn. Even when several major insurance providers, including Hartford Financial Group Inc. and Lincoln National, had to accept bailout money from the federal government, the variable annuity investors got paid.

Is a Variable Annuity the Right Choice for You?
Variable annuities with the downside protection guarantee represent a more conservative approach to retirement. Yes, they cost more than other options. Yes, the returns are lower. Yes, there are complex provisions that you need to understand before you buy and various limitations and restrictions that will apply after the purchase. There are also theoretical concerns about the long-term financial stability of the firms providing the benefits - although research into the topic is likely to reveal that the money is theoretically set aside at the time of investment and that the investors should expect to get paid no matter what happens to the insurance company.

Conclusion
If you understand the potential concerns and view them as inconsequential when compared to a guaranteed income, variable annuities may have a place in your portfolio. Of course, investing in a variable annuity doesn't mean that you should neglect other options. There's nothing wrong with maximizing the amount you invest in your employer-sponsored retirement savings plan or your IRA before committing cash to a variable annuity. Having a diversified portfolio can mean more than just having a mix of stock, bonds or cash in your account. It can also mean having a portfolio of your nest egg invested in a variety of different accounts, one of which just may be a variable annuity with a guaranteed payout. (For more, see Getting The Whole Story On Variable Annuities.)

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