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4 things you really need to know about your variable annuity

Approximately 1.7 trillion dollars are currently invested in variable annuities, a number that is swelling as baby boomers seek income for their retirement years.

Variable annuities are contracts between you and an insurance company, under which the insurer agrees to make periodic payments to you. Another way to think of them is as mutual funds run through an insurance company in order to get a tax deferral, according to James H. Hunt, an actuary affiliated with the Consumer Federation of America.

The tax deferral means you pay no taxes on the income and investment gains until you withdraw the money. Variable annuities are also subject to various restrictions and fees, typically quite high ones.

Andy Roberts | OJO Images | Getty Images

Before the financial crisis, insurers were offering variable annuities that, while generally seen as expensive, offered rich benefits. Some provided lifetime incomes that rose by 6 percent to 7 percent a year, no matter what happened with the underlying investments.

Those guarantees turned out to be expensive for the insurance companies. For the last few years, insurance companies that created variable annuities before the financial crisis have been offering buybacks to investors.

"As a general rule, these types of [buyout] offers tend to benefit the carrier and not the client," said Parsippany, N.J.-based financial advisor Mark Cortazzo.

This is a complicated picture for most people to understand. Many investors have misconceptions about this type of investment to begin with. Almost half of the participants graded themselves with a D or F in their understanding of annuities, according to San Francisco-based Koski Research.

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The buybacks, too, are complicated. One recent voluntary buyback by AXA Equitable, for instance, offers investors increases in account size of Accumulator annuities in exchange for giving up some guarantees, such as the guaranteed minimum income benefit (GMIB) and guaranteed minimum death benefit (GMDB).

The offers varied and were made on a rolling basis over 18 months to different clients. An AXA spokeswoman said the company was pleased with the outcome. Other insurers have been offering similar deals—and, depending on the terms of the contract, they're not always voluntary.

Before you buy a variable annuity or accept a buyout offer, take time to consider your own personal goals and objectives. Then ask these questions to evaluate whether this specific investment tool is right for you:


1. What are my fees?
A variable annuity contract most often contains fees, including but not limited to, mortality and expense risk charges (M&E), administrative fees, underlying fund expenses and other asset-based fees. Variable annuities also typically have surrender charges, which apply if the contract holder sells the contract or withdraws excess money during a specified period of time after the contract is purchased. Your financial advisor should be able to provide the total expense ratio, which is the percentage stated in the prospectus and includes most fees except for brokerage commissions and sales charges.

On an average variable annuity contract, the total expenses were $559 per $25,000 investment, according to Morningstar Annuity Research Center's semi-annual report on fees. Fees for optional benefits, such as the death benefit, are extra.

Once you identify the total annual cost for the variable annuity, determine if you are getting a good value for the cost.

Keep in mind that annuities have an insurance component. One of the benefits you buy is protection against the risk that you would lose your money in the market. It can be hard to value that protection, but Cortazzo, whose firm, MACRO Consulting Group, charges $199 to evaluate three annuity contracts for consumers, suggested thinking of it as you would insurance on another valuable asset. "Most homeowners lose money on their homeowner's insurance, but it may be the best money ever spent for the homeowner who has a house fire," he said.

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2. Where Is the best place to own a variable annuity?
You may have heard that you should never own an annuity in a retirement account, such as a 401(k) or IRA, because there is no additional tax advantage from the variable annuity. (Variable annuity gains are tax-free until withdrawal, when they are taxed as ordinary income.) A variable annuity provides a clear tax advantage in taxable accounts, but there may be ways to use a Roth conversion to capture some of a variable annuity's tax benefits, even in a retirement account. Ask an advisor or your accountant.

3. What is the financial strength of the issuer?
Another important factor to consider is the financial strength of the insurance company. Check the company's ratings with a third party, such as A.M. Best, S&P, Moody's or Fitch. This is significant because the guarantees on your variable annuity are based on the claims-paying ability of the insurance company.

If an insurance company is unable to meet its obligations, many contracts are protected by their state insurance guarantee fund up to a specified dollar limit, which can range from $100,000 to $500,000, but coverage varies by state. Check with your state department of insurance.

(Read more: Working for yourself? Don't forget retirement)

4. How valuable is my existing variable annuity?
Older variable annuity contracts often have benefits and features that are no longer available today, such as fewer investment restrictions, more generous payouts and better death benefits.

Variable annuity programs offered prior to the 2008 financial crisis were designed when interest rates were higher, market volatility was lower, and there was less concern about risk, in general. Many include higher guaranteed payouts and other benefits to the contract holder that aren't available today, Cortazzo said.

Typical buyouts offered by the insurance companies will offer one-time increases in your account value in exchange for lower guaranteed benefits, like the monthly payout. One question to consider is whether the fee basis is tied to your account value. Don't forget to take that increase into account when you are making a decision.

Your best bet when evaluating a variable annuity is to find an advisor or accountant to help you understand the benefits of the particular annuity—or, in the case of a buyout, the change to your contract. Just be aware that if you're speaking with an advisor who receives commissions for selling you a new annuity, he or she may not have your best interests at heart.

—By Elizabeth MacBride, Special to CNBC.com

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