What Is a Variable Annuity?

A variable annuity is a type of annuity contract, the value of which can vary based on the performance of an underlying portfolio of mutual funds. Variable annuities differ from fixed annuities, which provide a specific and guaranteed return.

Key Takeaways

  • The value of a variable annuity is based on the performance of an underlying portfolio of mutual funds selected by the annuity owner.
  • Fixed annuities, on the other hand, provide a guaranteed return.
  • Variable annuities offer the possibility of higher returns and greater income than fixed annuities, but there's also a risk that the account will fall in value.
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Variable Annuity Basics

Understanding Variable Annuities

There are two elements that contribute to the value of a variable annuity—the principal, which is the amount of money you pay into the annuity, and the returns that your annuity's underlying investments deliver on that principal over the course of time.

The most popular type of variable annuity is called a deferred annuity. Often used for retirement planning purposes, it is meant to provide a regular (monthly, quarterly, annual) income stream, starting at some point in the future. There are also immediate annuities, which begin paying income right away.

You can buy an annuity with either a lump sum or a series of payments, and the account's value will grow accordingly. In the case of deferred annuities, this is often referred to as the accumulation phase.

The second phase is triggered when the annuity owner asks the insurer to start the flow of income, often referred to as the payout phase. Most annuities will not allow you to withdraw additional funds from the account once the payout phase has begun.

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which offer a guaranteed, but often low, return. Variable annuities gave buyers a chance to benefit from rising markets by investing in a menu of mutual funds offered by the insurer. The upside was the possibility of higher returns during the accumulation phase and a larger income during the payout phase. The downside was that the buyer was exposed to market risk, which could result in losses. With a fixed annuity, by contrast, the insurance company assumes the risk of delivering whatever return it has promised.

Variable annuities should be considered long-term investments, due to the limitations on withdrawals. Typically, they allow one withdrawal each year during the accumulation phase. However, if you take a withdrawal during the contract's surrender period, which can be as long as 15 years, you'll generally have to pay a surrender fee.

Variable Annuity Advantages and Disadvantages

In deciding whether to put money into a variable annuity versus some other type of investment, it's worth weighing these pros and cons:

Pros

  • Tax deferred growth

  • Income stream tailored to your needs

  • Guaranteed death benefit

  • Funds off-limits to creditors

Cons

  • Riskier than fixed annuities

  • Surrender fees and penalties for early withdrawal

  • High fees

Here are some details on each.

Advantages

  1. Variable annuities grow tax-deferred, so you don't have to pay taxes on any investment gains until you begin receiving income or make a withdrawal. This is also true of retirement accounts, such as traditional IRAs and 401(k)s, of course.
  2. You can tailor the income stream to suit your needs.
  3. If you die before the payout phase, your beneficiaries may receive a guaranteed death benefit.
  4. The funds in an annuity are off limits to creditors and other debt collectors. This is generally true of retirement plans, as well.

Disadvantages

  1. Variable annuities are riskier than fixed annuities because the underlying investments may lose value.
  2. If you need to withdraw money from the account because of a financial emergency, you may face surrender fees. Any withdrawals you make prior to the age of 59 ½ may also be subject to a 10% tax penalty.
  3. The fees on variable annuities can be quite hefty.

Before buying a variable annuity, investors should carefully read the prospectus to try to understand the expenses, risks, and formulas for calculating investment gains or losses. Annuities are complicated products, so that may be easier said than done.

Bear in mind that between the investment management fee, mortality fees, administrative fees, and charges for any additional riders, a variable annuity's expenses can quickly add up. That can adversely affect your returns over the long term, compared with other types of investments.