What is a Variable Annuity?

A variable annuity is a type of annuity contract that allows for the accumulation and disbursement of capital on a tax-deferred basis. Variable annuities differ from fixed annuities, which offer a guaranteed return and a minimum payment at annuitization, in that there is no guarantee of a return, only the assurance that one will get back the principal paid.

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Variable Annuity Basics

Understanding Variable Annuity

There are two elements to an annuity - the principal, which is the amount paid into the annuity over a period of time, and the returns on that principal. The most popular type of annuity offered is called a deferred annuity. Often used for retirement planning purposes, it is meant to provide a retiree with a periodic (monthly, quarterly, annual) income stream.

Once an individual enters into a contract with the insurance company offering the annuity, they begin the process of paying into the account which is often termed the accumulation phase. The second part, and probably the one that is of the utmost importance to the investor, is the payout phase. This is triggered when the investor annuitizes the annuity, which is the process of converting this investment into a series of periodic income payments. Most annuities will not allow the investor to withdraw funds from that account once the payout phase has commenced.

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which offer a guaranteed return. Variable annuities do not guarantee a return. This is because they were designed to give individuals a chance to invest in professionally managed subaccounts, consisting of a mix of stocks, bonds and money market funds, that offer the possibility of higher returns leading to capital accumulation and a larger income stream. While this enables them to be more responsive to inflation than are fixed annuities, it also exposes them to market risk which could result in losses. The only advantage over a regular investment is that the investor's principal is guaranteed.

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.

Key Takeaways

  • A variable annuity is a type of annuity contract that allows for the accumulation and disbursement of capital on a tax-deferred basis.
  • There are two elements to an annuity - the principal, which is the amount paid into the annuity over a period of time, and the returns on that principal.
  • Variable annuities differ from fixed annuities as they offer no assurances of a guaranteed return or a minimum payment at annuitization.

Variable Annuity Advantages and Disadvantages

The main advantages of variable annuities are:

  1. They are tax-deferred which means that the buyer does not pay federal taxes until they receive income payments, make a withdrawal or a death benefit is paid out.
  2. The annuitization can be tailored in that the payment stream can be specified to the buyer's wishes.
  3. In case the buyer of the annuity dies before the payout phase, the beneficiary will usually receive a specified amount, almost like a guaranteed death benefit.
  4. Creditors and other debt collectors cannot go after the funds in an annuity.

The main disadvantages of variable annuities are:

  1. They are riskier then fixed annuities as there is no assurance of returns being generated.
  2. If there is a withdrawal then any capital gains are taxed as ordinary income. Withdrawals made prior to the age of 59 ½ may be subject to a 10 percent tax penalty.
  3. The fees can be quite hefty.

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.