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 valuation period is the time period during which value is ...
  3. Hybrid Annuity

    A hybrid annuity allows buyers to purchase fixed-rate and variable ...
  4. Delayed Annuity

    A delayed annuity is an annuity in which the first payment is ...
  5. Income Annuity

    An income annuity is an annuity contract that is designed to ...
  6. Annuity Consideration

    An annuity consideration is the money an individual pays to an ...
Related Articles
  1. Retirement

    How a Variable Annuity Works After Retirement

    These investments can provide extra income after you retire. Here’s a guide to when and how you will receive the payout.
  2. Retirement

    Who Benefits From Retirement Annuities

    Annuities guarantee some degree of fixed income in retirement. But is the security worth the fees and less favorable tax treatment? How to decide.
  3. Investing

    Things Your Annuity Salesperson May Not Tell You

    Your variable annuity salesperson should tell you many things. But there's a chance they'll leave out some crucial details.
  4. Financial Advisor

    Annuities: The Good, Bad and the Ugly

    Annuities suffer from a few perception problems. This primer that covers the good, the bad and the ugly of annuities.
  5. 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.
  6. Investing

    An Overview of Annuities

    As part of your overall investment strategy, annuities may add value to your retirement in more ways than you think. Here's how they work.
  7. 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 ...
  8. Retirement

    Taking The Bite Out Of Annuity Losses

    If this investment product has caused you sleepless nights, it's time to consider alternatives.
  9. Financial Advisor

    Advising FAs: Explaining Annuities to a Client

    Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
Trading Center