How variable annuities work: The facts & myths

The average 50-year-old American male can expect to live close to 82, based on Social Security Administration calculations; Women can add three years to this estimate. But will all those eighty- or ninety-something retirees have the freedom to enjoy their leisure time as they have throughout their careers, with enough income to keep pace with inflation? Variable annuities can help.

Jen Becker, a Thrivent financial advisor in Faribault, Minnesota, works with clients eager to preserve their lifestyle in retirement—and the most common question she gets? "How much do we need to retire?" The answer varies: "I've had clients with less than $100,000, but they have Social Security and a pension," she says. "But I also have people with millions, who won't be able to afford their current lifestyle." She sees the income guarantees of variable annuities as an increasingly popular tool for these clients.

With pension plans going the way of paper roadmaps in most corporations, Americans are losing a second stream of guaranteed income. In fact, 40% of Americans rely only on Social Security for income in retirement per the National Institute on Retirement Security's "Examining the Nest Egg: The Sources of Retirement Income for Older Americans" report. IRAs and 401(k)s are now the bedrock of retirement plans. But a market dip can quickly mitigate gains. This calls for a hedge against loss.

Variable annuities offer retirement-plan growth opportunities, while also guaranteeing income. These plans, which are most often geared to investors expecting to live into their 80s or 90s, may provide income from the pre-determined age that payments begin until death.

Here's an example: Say you're 10 or 15 years from retirement and you've received a lump sum of money, whether it's from an inheritance, an IRA or a 401(k). You've been maintaining a 60/40 balance among your investments: 60% is going towards growth, with the remainder in financial instruments which may carry less risk, such as bonds. You could deposit that lump sum into the account and maintain that balance—or you can open an annuity that will start payments when you turn 75, or whatever age you choose to begin cashing out an annuity.

Depending upon the amounts involved, you could either reduce or entirely eliminate your 40% of low-risk investments. The upshot: You can dedicate more of your retirement funds to more growth opportunities, while also creating guaranteed income for your later years.

In addition, variable annuities may offer attractive features such as tax-deferred deposits that can assist in more efficient tax planning. Or you can create a legacy by adding a life-insurance-like death benefit to your policy —though the primary focus is more typically on retirement income.

Are annuities a good idea? Anyone who reads about investing knows that annuities are somewhat controversial. "In the past, some people would hear that word annuity and run in the opposite direction," says Becker. Here are a few of the more common myths about these plans:

"Some people think annuity assets are 100% illiquid," says Becker. "There's always some liquidity, just not full liquidity."

Many types of variable annuities offer different types of returns—much of it depending on how their fund managers choose investments. There's also the consideration of sacrificing some growth in exchange for the security of guaranteed income.

"It's possible," says Becker. "And when you're younger and in the asset-accumulation stage, you want to hold down costs and seek maximum growth. Now fast-forward to distribution age. It's suddenly less about cost and more about creating income."

A variable annuity is only one part of a comprehensive retirement plan. Talk with a financial advisor about the potential future value of a variable annuity in supporting your total retirement vision.