Weston: Variable annuities are complex and filled with pitfalls

Variable annuities are complex insurance products — so complex that what people actually buy and what they think they are buying may be quite different.

Those misunderstandings can end up costing them, or their heirs, a lot of money.

Variable annuities are insurance-company contracts that allow people to invest money in a tax-deferred account for retirement. Returns can vary according to how the investments perform (that's the "variable" in "variable annuity"). These contracts typically include death benefits guaranteeing your heirs will get the amount you have invested, and perhaps more. Many variable annuities also have living benefits, which guarantee the amount you can withdraw during your lifetime. All these guarantees come at a cost, which can make variable annuities expensive to own.

Sales of variable annuities have slowed in recent years but were still estimated at about $100 billion in 2018. Since variable annuities have a lot of moving parts, and function differently from other investments, it is easy for holders to make a costly mistake. Such as:

Insurance companies have different policies about how money gets paid out when someone dies, and variable annuity owners need to understand what those are, says Edward Jastrem, a certified financial planner in Westwood, Mass.

For example, couples often own an annuity jointly, or name one spouse as the owner and the other as the "annuitant." (The annuitant is the person whose life expectancy determines how much is paid out if the contract is "annuitized," or turned into a stream of regular payments.) The couple often assumes any leftover money will be paid to the beneficiaries, typically the children, only after the second spouse dies. Some insurers do just that, but most pay the beneficiaries after the first death, disinheriting the surviving spouse, said annuity expert Michael Kitces of Columbia, Md.

Annuity owners should call the insurer to clarify what happens after the first death and change the beneficiary if necessary to make sure the money goes where they want, Kitces said.

The income base is a kind of phantom number that grows over time by a guaranteed amount, set in the contract. But annuity owners can tap this value only if they agree to start taking regular payments from the contract.

People often mistake guarantees of future income for guaranteed increases in their account value, said Randy Bruns, a CFP in Naperville, Ill. They are shocked to discover their annuities aren't worth as much if they want to cash out.

"Buyers commit sizable chunks of their nest eggs to variable annuities thinking they're getting all the upside of markets with a guaranteed return as a floor," Bruns said. "In reality, that guaranteed floor provides no insurance to what you'll receive if you cash out your contract."

The cash-out value can be quite different from the death benefit, as well. Cashing out or exchanging an annuity with a death benefit that's substantially larger than the account value could result in heirs getting much less than they might otherwise.

Living benefits on variable annuities purchased before the 2008 financial crisis could be quite generous, while today's are often less so, Kitces said. Also, contributions to variable annuities before 1982 get more favorable tax treatment than later versions, thanks to a change in tax law. Owners of these older policies should be careful not to unwittingly exchange them for newer, less favorable ones without understanding what they may be giving up, Kitces said.

"You can almost count on the agent circling back to move the money into the latest, greatest variable annuity so they can earn another commission and lock up the money again," Peterson said.

Because salespeople typically aren't required to put your best interests first, you would be smart to consult someone who is — such as a fiduciary fee-only planner — before buying, exchanging or cashing out a variable annuity.