What Is a Variable Annuity?
June 25, 2021
What Is a Variable Annuity?
June 25, 2021
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Variable annuities can help you meet your long-term financial goals and provide a guaranteed income stream in retirement, but they are not without their drawbacks and considerations. It’s important to understand how variable annuities work and the benefits and risks involved. Variable annuities offer the strongest return potential with the highest risk of all annuities.
What Is a Variable Annuity?
A variable annuity is an insurance contract between you and an insurance company. The returns you earn are based on the performance of an investment portfolio, so they are considered variable because your returns are not fixed and can change. This means you have the potential to lose money, which differs from other types of annuities. They do not offer a guaranteed payout—hence, the risk level is higher.
Variable annuities can be funded with a lump sum or series of payments. Variable annuities allow you to choose which funds (called subaccounts) you’d like the insurance company to invest your principal in. Subaccounts operate much like mutual funds invested in stocks, bonds, money markets, and any combination thereof. These subaccounts come with a prospectus available for your review—they may contain a lot of financial jargon and complex language, so make sure you understand this fully before selecting any investment. According to investor.gov, “you should consider a variety of factors with respect to each fund option, including the fund’s investment objectives and policies, management fees and expenses that the fund charges, the risks and volatility of the fund, and whether the fund contributes to the diversification of your overall investment portfolio.” Like all other annuities, your account value is a combination of your initial investment, the principal, and the returns that your underlying subaccounts deliver over time.
Variable annuities can be both immediate or deferred, meaning you could start receiving payments right away or at a later date, depending on what you elect when purchasing your annuity. A deferred variable annuity is more popular, as this type of annuity is considered more ideal as a long-term investment to give your principal time to grow and buffer against short-term losses. Like other deferred annuities, deferred variable annuities go through an accumulation period where the account’s value is invested and given time to grow. During the accumulation phase, you may be able to make transfers between subaccounts with no tax consequences. However, the insurer may charge fees to make transfers, so be sure to check before doing this. Once the annuitant elects to receive payments, the annuity enters the payout phase (or annuitization). You can receive a lump-sum payment (which may incur additional fees from the insurance company) or a series of payments.
Surrender period and fees are also attached to these types of annuities; as with most retirement accounts, a 10% penalty is incurred on withdrawals before the age of 59.5. Also, remember that extra features like death benefits can be added on for more flexibility and security—but for an extra, often high charge. A
Some variable annuity contracts will allow you to allocate a portion of your principal to a fixed account, which guarantees a minimum fixed interest rate and is not funded into the variable annuity. The insurer may review and revise this interest rate periodically, but there is usually a guaranteed minimum that the rate will not dip below. Some contracts also include a “bonus feature,” which adds a specified percentage of additional money (funded by the insurer) to your contract with your purchase payments. There are several considerations with bonus credits: They sometimes charge higher fees on these types of annuities, so it may be wiser to purchase an annuity without bonus credits but with lower fees. Also, this may only apply to your initial payment or payments made within a specified period of time.
What Is the Difference Between Fixed Annuities and Variable Annuities?
The main—and essential—differences between fixed and variable annuities are the return/growth potential and risk level. Fixed annuities offer a guaranteed, usually low return rate with no market exposure, meaning your principal is protected (and gains to a degree). With market exposure, variable annuities offer greater potential to see higher returns and more income in the payout phase; on the flipside, this can also result in losses, making it a riskier product.
Advantages and Disadvantages of Variable Annuities
Tax-deferred growth – you are only taxed when you make withdrawals from the account
Greater growth potential with possible inflation protection – as these annuities are tied to investment portfolios, which also tend to outperform inflation in most instances, you may be able to keep up better with inflation that with other investment options
Protection of principal – while your principal is protected, you’re not guaranteed any returns if the subaccounts do not perform well
Guaranteed death benefit – if you die before you start collecting payments, your beneficiary will receive a portion or all of the money in your account; this is not free—you do pay for this as part of the fees
Illiquid, especially during the accumulation phase – you may have little to no access to your money during the accumulation phase and will have to pay surrender fees to access your money early
Riskier and more complex than other types of annuities – exposure to market gains and losses
High fees, including surrender fees, early withdrawal penalties, extra riders, commissions, mortality and expense risk charges, underlying fund expenses, and insurer fees
Taxes paid at federal income tax rates, not lower capital gains rates
Like all annuities, make sure you understand the fees involved in your contract. They can add up quickly, especially for a more complex product like a variable annuity. Variable annuities are a bet: You’re betting that your returns will outweigh the high fees and costs associated with these annuities. Variable annuities are classified as securities and are registered with the SEC, which means they’re more heavily regulated. They are considered investments and may not be protected from creditors as other annuities are.
As with all investments, diversification is important. You should use annuities as a secondary savings option—not your sole retirement investment vehicle. Consult a financial professional before taking on the risk of a variable annuity. Keep in mind that annuities do not equate to ownership of individual stocks, index funds, or mutual funds. They are also not insured by the FDIC, any federal agency, or any bank. Annuities are backed by the financial strength and paying ability of the issuing company. As annuities are illiquid, they do not offer immediate or flexible access to money; they are part of long-term retirement strategy.
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