Besides growing your own company, what is the best investment a small-business owner can make? This is a simple question that lacks a simple answer. For owners who have most or all of their net worth tied up in their business, it’s important to take some of that value and invest it in something that carries a different risk profile.
If you are in a stable, low-return business, then using some of that excess cash for investments that could provide a better return on your money is a good idea. However, if your small business is inherently risky, then it’s best to put excess money in stable and secure investments to offset the risk of your business. Many financial companies are aggressively promoting the purchase of variable annuities to both audiences, those with an appetite for risk and those looking for stability. It would seem then that variable annuities are the answer to everyone's financial hopes and fears. They only seem that way; in reality small-business owners with capital to invest should proceed cautiously when it comes to variable annuities.
Variable Annuities Primer
A variable annuity is an investment product that is typically sold by insurance companies and offers features not found in other types of investments. The money you invest in a variable annuity is put to work in the stock market, bond market and other traditional investment markets, similar to how a single mutual fund purchase allows you to invest in many different types of assets.
When you invest directly in the stock or bond market, you always run the risk of losing everything if you make bad investment choices. This is where a variable annuity differs; it offers certain guarantees on your rate of return, like an insurance policy on your investment. So even if the money manager running the variable annuity loses money, you are still guaranteed a minimum return on your investment. In exchange for this guarantee, you pay a fee.
While in theory variable annuities offer the best of both worlds, it’s important to take a closer look at the key features.
The guarantee portion of the annuity is typically expressed as a rate of return, such as 2 percent or 4 percent over the life of the annuity. This guarantee is not absolute. It is issued by an insurance company, which is subject to the realities of the current and future economic climate. It’s important to investigate the credit rating and overall credit quality of the insurance company underwriting the annuity. If there is any question at all as to their long-term financial soundness then you should proceed with extreme caution. Insurance companies with slightly dinged credit ratings tend to offer higher guarantees (and juicier commissions) but this is not in your interests. Also, some of the guarantees are not absolute and are instead subject to specific parameters and conditions which should be explained to you before the purchase.
Variable annuities come with multiple fees. First there is the fee to the company that sells the annuity. If the variable annuity invests in mutual funds, like most do, then you also have the fund management fees. Finally you have the fees associated with the guarantee. These fees can add up to 4 percent or more.
If you were to buy a $500,000 variable annuity today, then over a 20-year period each 1 percent in fees could roughly cost you $100,000 in potential return. If you change your mind and want out, that also can carry a hefty expense.
If you have doubts about variable annuities, then there are many alternatives available. Funding a retirement account available to small-business owners gives you access to investment products that together can offer many—but not all—of the benefits of a variable annuity. It also allows you to shelter that money from taxes and invest it. This allows you to generate a return on money you would have otherwise turned over to Uncle Sam. You will eventually pay taxes, but not until you take the money out, at which point you will likely be older, retired and in a lower tax bracket.
Before making any decisions on variable annuities, you should consult with your financial advisor and accountant since this is a personal decision. But it’s important to begin the discussion with awareness that these products are marketed aggressively because they make for a great pitch and the commissions are high. Caveat Emptor.
Mike Periu is the founder of Proximo International, LLC a leading provider of corporate, consumer and small business training services including financial and business educational content for television, radio, print and online distribution in both English and Spanish.
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