What are the pros and cons of a variable annuity?

Variable annuities can offer income in retirement and the potential for higher returns, but those perks come with trade-offs, including higher fees, limited liquidity and market risk.

Before you commit, it’s important to weigh the pros and cons of variable annuities and make the right decision for you.

What is a variable annuity?

A variable annuity is a contract between you and an insurance company that can provide income in retirement.

All annuities work like this: You pay a lump sum or a series of premiums to the insurer who then makes regular payments back to you in retirement or however long you choose.

Variable annuities differ in that the value of the annuity is based on the performance of underlying investments — often mutual funds. The value of your annuity can rise or fall based on how the investments you selected fare.

Variable annuities tend to be more suitable for investors with higher risk tolerances who have maxed out other retirement plans.

Pros and cons of variable annuities

Annuities in general have an abundance of fees that may be charged annually based on the value of the contract. Variable annuities have even higher fees and higher risk, so you’ll want to be extra thoughtful when considering if an annuity is the right investment for you.

Here’s an overview of the pros and cons that come with a variable annuity.

Pros

A variable annuity may be attractive if you want retirement income with the opportunity for higher returns and have a higher risk tolerance.

• Income in retirement: Like other annuities, variable annuities offer an income stream in retirement and beyond if you choose.
• Growth potential: Variable annuities offer the chance at higher returns because the payout amounts depend on the performance of underlying investments.
• Tax-deferred growth: Earnings within annuities accumulate on a tax-deferred basis until withdrawn, the same way a traditional 401(k) does.
• Someone else manages the fund: The insurance company is responsible for managing the investments that you pick, so you don’t have to worry about it.

Cons

There are some drawbacks to keep in mind anytime you consider an annuity but especially a variable annuity, which adds in higher fees and market risk.

• Fees: The fees associated with a variable annuity are higher than most annuities — and even other financial products — due to the underlying investments and more intricate contracts. You might pay 3 to 8 percent in fees for a variable annuity, excluding commission and surrender charges.
• Market risk: Because the value of your annuity depends on the underlying investments, there’s a risk that your annuity loses value when the market declines.
• Limited liquidity: It’s extremely challenging to take money out of an annuity once you’ve started receiving payments. If you choose to withdraw the money early, you’ll be faced with surrender charges.
• Sales practices: You may run into an insurance broker or financial advisor who only suggests an annuity to you because of the high commissions, which can range from 1 to 8 percent.

Bottom line

Are the pros of a variable annuity worth the cons? There’s no one right answer. It depends on your risk tolerance, time horizon and financial goals. Broadly, those who want a retirement income may benefit, but be mindful of the high fees, strict contracts and limited liquidity.