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What is a 'Variable Annuity'

A variable annuity is a type of annuity contract that allows for the accumulation of capital on a tax-deferred basis. As opposed to a fixed annuity that offers a guaranteed interest rate and a minimum payment at annuitization, variable annuities offer investors the opportunity to generate higher rates of returns by investing in equity and bond subaccounts. If a variable annuity is annuitized for income, the income payments can vary based on the performance of the subaccounts.

BREAKING DOWN 'Variable Annuity'

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which offer a guaranteed rate of interest. Variable annuities allow investors to invest in a dozen or more professionally managed subaccounts consisting of various asset classes, including stocks, bonds and money market funds. This gives investors the opportunity to earn higher rates of return, which can increase the amount of capital they can accumulate and provide a variable income stream to potentially outpace inflation. However, investors assume the risk of their subaccounts not outperforming a fixed annuity's guaranteed return, which can result in less capital accumulation and a smaller income stream.

Variable Annuity Pros and Cons

One advantage variable annuities have over mutual funds is the guaranteed death benefit feature. Regardless of how the subaccounts perform, a variable annuity death benefit ensures the annuity owner’s beneficiaries receive no less than the initial investment. Variable annuity investors pay for the cost of that protection through a mortality charge. For an added charge, some variable annuities offer a minimum rate guarantee that pays a minimum rate of return, even if the subaccounts experience a loss for the year. A similar rider is offered for income payments at the time of annuitization that guarantees a minimum payout rate regardless of the performance of the subaccounts.

Variable annuities should be considered as a long-term investment due to the limitations on withdrawals. One withdrawal is allowed each year. However, if a withdrawal is taken during the contract's surrender period, which can be as long as 15 years, a surrender charge is applied. Because variable annuities are tax-qualified investments in which taxes are deferred, withdrawals are taxed as ordinary income. Withdrawals made prior to the age of 59 ½ may be subject to a 10 percent tax penalty.

Before investing in a variable annuity, investors should carefully read the prospectus for a full understanding of the expenses and risks. Between the investment-management fee, mortality fees, administrative fees and charges for any riders, a variable annuity's expenses can quickly add up, which can adversely affect returns over the long term.

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