What Is a Variable Annuity?
Let me explain what a variable annuity is. It's a type of investment income stream that rises or falls in value periodically based on the market performance of the investments funding it. If you're considering creating an annuity, you have the choice between a variable one or a fixed one.
An annuity is a financial product offered by insurance companies and available through financial institutions. You pay a lump sum or make a series of payments to fund it, and it guarantees a series of payments starting at a future date. These are commonly used to create a regular stream of retirement income.
The fixed annuity, as an alternative, establishes the payment amount in advance.
Understanding Variable Annuities
A variable annuity comes from a contract between you and an insurance company. You make a lump sum payment or a series of payments to fund it, and payouts begin at a future date.
You have options here. Payments can continue for your life, or for your life plus a surviving spouse's, or for a set number of payments. One key decision is whether to go variable or fixed, where fixed sets the payment amount ahead of time.
How Variable Annuities Work
In a variable annuity, each payment amount varies based on the performance of an underlying portfolio of sub-accounts. These sub-accounts are like mutual funds, though they lack ticker symbols for easy tracking.
Two factors determine the payments: the principal you pay in advance, and the returns from the annuity's underlying investments over time.
The most common type is a deferred annuity, often for retirement, providing regular income starting later. Immediate annuities start paying right after funding.
You can fund it with a lump sum or payments, and the value grows over time—in deferred cases, this is the accumulation phase. The payout phase starts when you request income flow, and some won't let you withdraw extra once it begins.
These are long-term investments with withdrawal limits. Typically, one withdrawal per year during accumulation is allowed, but during the surrender period—up to 10 years—you'll pay fees. Growth is tax-deferred like IRAs, with penalties for withdrawals before 59½.
Variable Annuities vs. Fixed Annuities
Variable annuities emerged in the 1950s as an alternative to fixed ones, which guarantee a payout—often low—during annuitization. Fixed income annuities are an exception, with moderate to high payouts increasing with age.
With variable annuities, you can increase income if investments perform well, choosing from the insurer's mutual fund menu. This offers higher return potential but exposes you to market risk and possible losses. In fixed annuities, the insurer bears the risk of delivering the promised return.
Variable Annuity Advantages and Disadvantages
When deciding on a variable annuity versus other investments, consider these pros and cons directly.
Advantages
- They grow tax-deferred, so you pay no taxes on gains until income or withdrawals start, similar to IRAs and 401(k)s.
- You can tailor the income stream to your needs.
- If you die before payout, beneficiaries may get a guaranteed death benefit.
- Funds are off-limits to creditors, like most retirement plans.
Disadvantages
- They're riskier than fixed annuities since investments can lose value.
- Emergency withdrawals may incur surrender fees and a 10% penalty before 59½.
- Fees on variable annuities are quite high.
Frequently Asked Questions
What is an annuity? It's an insurance product guaranteeing payments at a future date based on your deposits. The company invests until disbursing payments, which may last your life or a set period. Annuities have higher fees than most mutual funds.
Which earns more: variable or fixed? There's no clear answer. Variables have growth potential but can lose money and have high fees cutting profits. Fixed ones pay lower but stable rates. Review options carefully.
Are annuities FDIC-insured? No, they're not bank products, but state guaranty associations protect them if the insurer fails.
The Bottom Line
Before buying, read the prospectus to grasp expenses, risks, and gain/loss formulas. Annuities are complex, and fees like management, mortality, and administrative—plus rider charges—add up quickly. This can hurt long-term returns compared to other retirement investments.
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