NEW YORK (CNNMoney) -- We own some mutual funds that are doing well. But our financial adviser would like us to sell them and invest the proceeds in a variable annuity. Do you think this is a good move? -- Renate M.
I don't want to give the impression that every time a financial adviser recommends a variable annuity it means he's up to no good.
But when you consider the plethora of dubious sales tactics that have been used to peddle variable annuities over the years and the fact that both insurance and securities regulators stress caution when faced with an annuity pitch, it's only prudent that you should be wary.
In fact, I wouldn't even think of following an adviser's recommendation to sell funds and invest in a variable annuity until I asked him the following three questions -- and then took some time to weigh the answers, either alone or with the help of another adviser who doesn't have a vested interest in my decision.
Question 1: Why, exactly, do I need a variable annuity?
You say the mutual funds you own are doing pretty well. But even if their performance were lagging, you could just as easily replace them with other funds. So why is the adviser suggesting you go into a completely different type of investment?
I suspect the adviser is going to offer two reasons, either individually or in combination.
The first is tax-deferral. When you invest in a variable annuity, you get to spread your money among investments known as "subaccounts" that are much like mutual funds in that they allow you to invest in a portfolio of stocks, bonds or both. But unlike with a regular mutual fund, any investment gains generated by the subaccount go untaxed, as long as those gains remain within the annuity. This tax-deferral has the potential to boost your after-tax returns beyond what you might earn in taxable investments like conventional mutual funds.
But that potential comes with a downside: When you eventually withdraw investment gains from a variable annuity, they are taxed at ordinary income tax rates even if those gains are long-term capital gains. That means that the same capital gain that would be taxed at no more than 15% today in a mutual fund could be taxed at a rate as high as 35% in a variable annuity.
In effect, by investing in a variable annuity, you may be turning gains taxed at 15% into profit taxed at 35%. That difference can pretty much destroy any benefit of an annuity's tax deferral and erode, if not eliminate, a variable annuity's value as a vehicle for building a nest egg.
The second reason your adviser might say you need an annuity is for guaranteed retirement income. It's true that most variable annuities sold these days come with a rider known as a GLWB, or guaranteed lifetime withdrawal benefit. This rider assures that you can draw a given percentage of the annuity's value (usually 4% to 6%, depending on your age) throughout retirement. Annuities with this rider also often tout a guaranteed rate of return.
But this income benefit and the return guarantee can be devilishly difficult to evaluate. And after you've taken the effort to do that, you'll often find that these benefits (much like the tax-deferral mentioned above) sound more appealing than they actually are.
Question 2: What will the annuity cost me?
Most of the variable annuities sold by advisers are weighed down by several layers of fees.
As this Securities and Exchange primer on variable annuities points out, there are insurance charges, investment management fees and fees for various riders and extra features. These can often total upwards of 3% a year. There are also surrender fees if you pull out your money within a certain period of time (typically six to eight years) after buying.
What's more, ascertaining exactly how much you'll pay in fees is tough for most investors, as it can require slogging through a long mind-numbing prospectus. (For a look at a simpler, quicker way to disclose annuity fees that I've proposed, check out my "E-Z Annuity Fee Disclosure Checklist.")
Question 3: Can I achieve my goal without a variable annuity?
Although salespeople may make it seem like a variable annuity is, if not the only, then certainly the ideal solution for your needs, I find that there are usually better ways to go.
When it comes to building a nest egg, you should certainly go with 401(k)s and IRAs first. And even after you've maxed them out, I'd say tax-efficient index funds and tax-managed mutual funds rank ahead of variable annuities as wealth-building vehicles.
And while a variable annuity with a lifetime income rider can provide reliable income throughout retirement, I think a combination of mutual funds and a plain old-fashioned immediate annuity is a smarter and less costly way to go.
I suggest you take some time to mull this over before making a move. During that time, you can also get a better handle on how annuities work by checking out the Annuities section of our Ultimate Guide to Retirement.
If the money you've invested in funds represents a significant portion of your savings -- or you're just not confident about sorting through these issues alone -- you might want to consult an adviser who will be willing to work for an hourly fee (and thus have no interest in selling you an annuity or any other product).
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