Variable annuity pros & cons: What to know before you buy

You can take many approaches to investing your retirement savings. Some strategies may seek to maximize investment growth while others are better for providing secure income. Variable annuities are an option that may provide both, but that doesn't mean they're the best choice for everyone. Understanding the potential advantages and disadvantages of a variable annuity can help you decide if one might fit into your retirement plan.

We'll cover:

• What is a variable annuity?
• Variable annuity advantages
• Variable annuity disadvantages
• Is a variable annuity worth it?
• Alternatives to variable annuities

A variable annuity is an insurance contract where you invest money into subaccounts tied to the market. During the accumulation period, a time when you save and potentially grow the value of your annuity to prepare for your retirement needs, your annuity's contract value will rise or fall based on the performance of the underlying investments you selected.

Later when you’re ready to retire, you can convert the value of your annuity into a stream of payments that can last for your entire lifetime.

Higher gains during the accumulation period will translate into higher future payments, while lower gains, or losses, will result in smaller payments.

In the right situations, variable annuities can offer several advantages for your retirement plan including the potential for your investment to experience tax-deferred growth, a standard death benefit, and the option for lifetime retirement income.

The most distinct feature of a variable annuity is the ability to grow your contract value by investing your premiums. Subaccounts can help a variable annuity’s growth keep up with, and sometimes outpace inflation, a common risk to your retirement savings. However, subaccounts are dependent upon market risk and performance.

Because variable annuities also may fall in value, you may have the option to purchase a guaranteed lifetime withdrawal benefit (GLWB) rider, for an additional cost, so your GLWB guaranteed withdrawals don't fall below a certain amount, regardless of how your investments perform.

A variable annuity’s earnings are tax-deferred. That means they aren’t taxed while you’re contributing to the annuity, which may result in higher growth from compound earnings.

And, because variable annuities are usually a type of deferred annuity, you don't owe taxes on it until you begin receiving distributions. At that time, the money is subject to income tax.

During the accumulation stage when you're making contributions but not yet receiving payments, your beneficiaries are protected by a standard death benefit included with most variable annuities. This means that your heirs would receive a payout if you die before taking withdrawals.

Usually, the death benefit is equal to the amount you've contributed. If you've taken any withdrawals from your variable annuity, the amount distributed to you reduces the death benefit. However, investment losses don't reduce the death benefit. This can help you feel good about investing in your financial security without putting your beneficiaries at risk.

One of the unique features of an annuity is that it allows you to select a settlement option when you’re ready to set up a dependable stream of income for retirement. Payments will depend on your contract value at the time you elect the settlement option.

Choices may include:

• Single life income: Pays you an income for the rest of your life.
• Joint life income: Pays an income for the lives of you and your spouse.
• Fixed period installment agreement: Guarantees an income payment for the period you choose (up to 30 years).
• Fixed amount installment agreement: Guarantees an income payment in the amount you choose for as long as there’s money left in your contract.

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Fixed annuity vs. variable annuity: How do they compare?

Fixed and variable annuities are two options that offer tax-deferred growth on your contributions—though they do it in different ways. Compare the differences as you plot out your retirement income plan.

Dive deeper

No product is the right fit for everyone, and variable annuities are no exception. Despite their benefits, they have some disadvantages including the risk of loss, complexity and costs.

All investments involve some element of risk. Because variable annuities allow you to invest your premiums into subaccounts that expose you to the changing market, your variable annuity can lose value.

Be mindful of your risk tolerance and reasons for purchasing the annuity when you select subaccounts. Some options are more aggressive, and therefore riskier, while others may provide more stable but modest returns.

To keep your assets invested the way you want them to be, you can have them rebalanced. It’s an easy way to make sure you’ll continue to invest according to your risk tolerance.

Although variable annuities share a basic structure, contract options may vary between insurers and sometimes even between different variable annuities from the same insurer. The inconsistency can become difficult to navigate when reviewing contract details.

Before you purchase a variable annuity, understand what you're buying and how your contract is written.

One of the biggest drawbacks of variable annuities is that they come with fees. This includes a mortality and expense fee, which is typically between 1% and 2% per year in addition to the underlying fund expenses. You also may pay an additional fee for any optional riders you choose. This often makes them more expensive than investing in mutual funds.

Variable annuities are meant to be long-term investments. That means that you may face charges and penalties if you withdraw from your annuity within a certain time, called the surrender charge period. This is typically seven years, although it varies.

You also may be subject to an early withdrawal tax penalty if you withdraw from your contract before you reach 59½, unless an exception applies.

Variable annuities can give you a way to invest your money and convert it into a fixed income at a later date. A variable annuity can help you grow your savings if you don't mind the potential volatility.

If variable annuities aren't for you, you may want to consider a fixed annuity. There are several types of fixed deferred annuities that offer similar benefits, such as tax deferral and guaranteed income options, but with less risk. Just be aware that they don't offer the same growth potential as variable annuities.

• A fixed rate annuity earns interest at a guaranteed minimum interest rate for the life of the contract, so you know in advance how much your annuity will grow. These may be best for conservative investors whose top priorities are a guaranteed minimum interest rate and a reliable source of retirement income.

• A fixed indexed annuity has an interest rate that fluctuates based on the performance of a market index, such as the S&P 500, up to a cap. If the index has positive returns, you may earn more interest than you would with a fixed rate annuity. These may be best for people who want the opportunity to earn a higher interest rate with protection from market losses.

• A multi-year guarantee annuity (MYGA) earns interest at a guaranteed rate for a specified period, typically three to nine years. At the end of the period, you typically have these options: You can withdraw your funds, renew your annuity at then-current rates, choose an annuity payment option, or leave the money with the insurer, where it will earn interest at a renewable one-year rate set by the company. These may be best for people who want a guaranteed interest rate for a specified time period.

Variable annuities can give you the ability to accumulate additional retirement savings that you can turn into a steady stream of income. Despite the benefits they provide, they aren't the right choice for everyone. For guidance on evaluating your annuity options, contact a Thrivent financial advisor near you.