How to Balance Your Variable Annuity

Retirement savers are starting to get serious. After years of saving at anemic levels, and then suffering through one of the worst economic downturns in our history, people of all generations are gearing up, and, as evidence, last year saw a record number of variable annuity purchases. The resurgence can be attributed to some of the new features that have been introduced over the last several years which make variable annuities extremely attractive to risk-oriented and risk-adverse investors alike. With new options available that can guarantee income, withdrawals and even principal, variable annuities are as close as any investment  to becoming the “best of all  worlds”.

Even with that, variable annuities are not for everyone. It is recommended that only those people with an understanding of how investments work and are familiar with market risk consider them.  As with any investment tied to the fluctuations of the markets, variable annuities are not the type of vehicle that you can set and then forget.  In order to maximize the long term return opportunities, and to optimize the product to best fit your needs, the investments within a variable annuity contract require at least a moderate level of management.  Establishing the proper diversification and balance to match your investment profile is the first, critical step. But, once the investment accounts go to work, they will almost certainly require ongoing management to maintain the proper level of diversification and balance.

Let’s consider an example of a variable annuity investment allocation.  The investor is in his late forties. With 20 years on his time horizon, he is able to accept a moderate level of risk in order to increase his potential return, so he creates a balance that is heavily tilted towards equities, but only 20% is allocated toward higher risk stocks. With his initial deposit of $100,000, he  allocates the funds among five different investment accounts: $30,000 in a large cap growth account; $20,000 in an international stock account; $20,000 in a balanced growth and income account;  $20,000 in a corporate bond account; $10,000 in a fixed income account.  It is well-balanced between growth potential investments and more stable income oriented investments – about 70/30 which is appropriate for his age.

During the course of the next year, the international markets flourish and the international stock account increases by 20% . The large cap fund also increased by 12%.  Because the stock and bond markets don’t always move in the same direction, his income oriented accounts, the balance account and the corporate bond account decreased by 6%. So, at the end the year, his allocation now looks like this: International stock account – $24,000; large cap growth account – $33, 600; balanced account – $18,800; corporate bond account – $18,800; fixed account – $10,400.  The balance between growth and income has changed to about 75/25.

While the increase in his growth accounts is a positive thing, the fact that his portfolio balance is more tilted towards growth means it no longer matched his investment profile.  If the same trend were to continue for the next couple of years, the portfolio can get further out of balance.  As long as the markets are working in his favor, there may be a temptation to leave well enough alone. However, should they turn against him, his portfolio has greater risk exposure than he may be willing to tolerate.  In order to ensure the portfolio matched his risk tolerance, he needs to re-balance his accounts by moving funds from his growth accounts into his income accounts to achieve the 70/30 balance.  It is also important to keep in mind that, as he gets older, he may want to adjust his balance for greater emphasis on the stable, income accounts, which may require more re-balancing.

The other reason to balance your accounts is to ensure that you lock in any gains. If, after that first year of gains in the growth accounts, the markets turned and declined by 20%, the prior year’s gains would be wiped out.  By adjusting the accounts, moving some of the gains into the stable accounts, he could minimize the losses or even achieve more gains if the stable accounts performed well.

Variable annuities are ideal, because they do allow you to transfer funds between the accounts several times a year without charge, and better yet, with no tax consequences which is not the case when transferring between mutual fund accounts.

It’s a Balancing Act

One of the main criticisms of variable annuities are their high expenses, sometimes averaging as much as 1.5% more than a mutual fund.  And, if you add any of the guarantee options, it can add another .05% to 1%. Investors who have been ravaged in the markets probably won’t mind paying the extra cost for the peace-of-mind of those guarantees.  But, it makes it all the more important to ensure that you are maximizing your investment returns while maintaining the proper balance in your portfolio. The race to retirement is not a sprint, it is a marathon which requires thoughtful pacing and steady progress. There is no need to take big risk if you are able to achieve consistent, stable returns.  And that is best achieved through a well-balanced portfolio.