Welcome to the 2-Minute Money Manager, a short video series in which we answer money questions submitted by readers and viewers.
The topic of today’s discussion is variable annuities, specifically whether they are the best option for those approaching retirement.
Watch the video below to learn some useful information.Alternatively, scroll down to read the full transcript of what I said.
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Check out 11 Pointers to Investing in Your 60s and Beyond and 8 Surprising Things Nobody Tells You About Retirement for more information.You can also use the search box at the top of the page to look up information on annuities and find a wealth of information on the subject.
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If you have a question, scroll down past the transcript.
If you don’t want to watch the video, here’s what I said in it:
Hello, and thank you for visiting your 2-Minute Money Manager.MoneyTalksNews has brought you this answer, and I’m your host, Stacy Johnson.Since 1991, com has provided the best in personal finance news and advice.
Suzanne has asked us a question today.
We keep hearing, Stacy, that the stock market is about to crash.I’ve reached the age of retirement.Please provide me with some information about Vanguard’s variable annuity.Is this a better option than a 500 index or a bond index fund?
Let’s start by defining a variable annuity, then go over the benefits and drawbacks.
What exactly is a variable annuity?
A variable annuity is a mutual fund offered by an insurance company rather than an investment firm.A mutual fund is a pool of stocks, bonds, or both that have been divided into shares.
Owning a piece of a diversified portfolio is safer than owning individual stocks or bonds, which is why you invest in a mutual fund.
Returning to variable annuities, why would we want to invest in a mutual fund from an insurance company? Insurance companies provide features that other investment sources do not.
Variable annuities provide tax deferral, which means you won’t have to pay taxes on the profits as long as you keep your money in the investment account.The idea is to save money in an IRA or 401(k) and then withdraw it when you’re retired and presumably in a lower tax bracket.
Annuities, like retirement accounts, allow you to name a beneficiary in advance.As a result, if you die, your money will go directly to your beneficiary, bypassing probate.
There are also fixed and immediate annuities, in addition to variable annuities.
Variable annuities have a number of benefits.
I just mentioned a couple of annuity benefits: tax deferral and avoidance of probate.However, there’s more.
Some variable annuities include a death benefit that is guaranteed.Let’s say you invest $100,000 and the stock market crashes, causing your account’s value to plummet.However, if you die, your beneficiary cannot receive less than the $100,000 you invested.
A newer version of variable annuities has a feature called a guaranteed minimum income benefit, or GMIB, which goes even further.
This is similar to the death benefit I just described, but instead of starting when you die, it starts while you are still alive, specifically when you retire and convert your account from a lump sum to a monthly income stream.This is referred to as annuitization.
A guaranteed minimum income benefit, as the name implies, means that your monthly payments will be guaranteed.In other words, if the value of your account increases, your monthly income will increase accordingly.However, if the value drops, your monthly payments will be based on the amount you invested, not the current value.
There are also differences.For example, regardless of the account’s actual performance, your income could be based on a minimum of 6% annual growth.It could also be based on the highest balance the account has ever had.
In a nutshell, a guaranteed minimum income benefit provides the upside potential of stocks or bonds without the risk of losing money.If the value of your account rises, you’ll have a higher monthly income when you annuitize.However, if it falls, your monthly income will not be affected.
The GMIB is also known as the guaranteed retirement income program (GRIP) or the guaranteed interest account (GIA) by different annuity providers.
Now that we have all of this information, let us return to Suzanne’s question.She wonders if a variable annuity is safer than a regular mutual fund, such as a 500 index or a bond index fund. The guaranteed income benefit suggests that a variable annuity is indeed safer.
Unfortunately, there is no such thing as a free lunch.
Variable annuities have a number of drawbacks.
Variable annuities have a number of drawbacks, the most significant of which is their high fees.
Management fees of 2% per year can be found in even the most common variable annuity.Vanguard’s 500 index fund, on the other hand, charges nothing.1%As a result, variable annuity fees are much higher.
And that’s just the administration fee.Remember that death benefit I mentioned earlier? There’s also a fee for that.In addition, there is a fee for the guaranteed income benefit.As a result, variable annuity fees can be extremely high, especially when compared to traditional mutual funds.
Surrender penalties on variable annuities can be substantial and last a long time.Surrender penalties for the first five years, or even ten years in some cases, are common.Withdrawals from an IRA or other retirement account before the age of 59 are also taxed and may be subject to a 10% IRS penalty.
If Suzanne bites,
Suzanne may benefit from a variable annuity with guaranteed income benefit if she is saving for retirement, is risk averse, and intends to convert her investment into an income stream in the future, provided she understands the fees and restrictions.
She recommends the Vanguard variable annuity, which is a good option.Vanguard is a low-cost provider with people you can talk to who aren’t paid on commission, unlike many other investment firms.
Which brings me to my final suggestion: If you’re going to buy insurance, please avoid commissioned salespeople, no matter who you go to.
I’m not implying that all commissioned salespeople are crooks, but commissions are frequently followed by high fees.As a result, avoiding commissioned salespeople when looking for investment products will pay off.
Suzanne, I hope this has been of assistance to you, and I also hope you’ll all be able to meet me right here next time.
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In 1991, I founded Daily Money Life.I’m a CPA with additional certifications in stocks, commodities, options, mutual funds, life insurance, securities supervision, and real estate.
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