Loading the player...

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.

RELATED TERMS
  1. Immediate Variable Annuity

    An immediate variable annuity is an insurance product where an ...
  2. Valuation Period

    The time between the end of the business day of the first business ...
  3. Whole Life Annuity

    A Whole Life Annuity is a financial product sold by insurance ...
  4. Qualifying Annuity

    A Qualifying Annuity is similar to any other annuity except it ...
  5. No-Load Annuity

    A No-Load Annuity is a type of variable annuity that comes with ...
  6. Annuity

    An annuity is a financial product that pays out a fixed stream ...
Related Articles
  1. Investing

    What Do You Need to Know About Annuities?

    There are varying views on annuities. Use this basic information to draw your own conclusions.
  2. Investing

    Just Say No to Variable Annuities

    Sellers of variable annuities make them sound great to earn their commission, but they are not.
  3. Investing

    The Disadvantages of Annuity Contracts

    The disadvantages of annuities aren't always fully understood.
  4. Investing

    Should You Buy an Annuity?

    There are both pros and cons of buying an annuity, so do your due diligence before investing in one.
  5. Retirement

    Watch Your Back In The Annuity Game

    Find out how to get the upper hand when dealing with this payout challenge.
  6. Retirement

    Getting the whole story on variable annuities

    When you've maxed out your annual contributions to 401K, IRA, and other tax-deferred investment vehicles, variable annuities may be your alternative source to save money tax-deferred. But don't ...
  7. Financial Advisor

    Advising FAs: Explaining Annuities to a Client

    Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
  8. Retirement

    Should Your 401(k) Be In An Annuity?

    Housing your retirement plan inside a variable annuity contract offers some big advantages, but only if you are close to retirement.
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center