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A variable annuity is a type of annuity whose value is tied to the performance of an investment portfolio. Payments from variable annuities can increase if the portfolio performs well and decrease if it loses money. Although variable annuities carry the potential of higher returns than fixed annuities, they don’t offer a guaranteed payout.

Annuities can be customized to fit your particular needs and comfort with levels of risk.

The most straightforward types of annuities are fixed annuities, which carry a guaranteed, predictable interest rate over the course of the annuity contract.

Indexed annuities aren’t as predictable, as the amount of the payments you receive will be tied to the performance of a particular stock index, such as Standard & Poor’s 500. They also have a guaranteed, minimum return, even if the market does poorly. These annuities can be costly and complicated.

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What Is a Variable Annuity?

A variable annuity is a contract between you and an annuity provider — usually an insurance company — in which you purchase the ability to receive a stream of income for your life or a set period of time. The money you pay is allocated to an investment portfolio. You may have the ability select a predetermined portfolio that aligns with your risk tolerance, time horizon and investment objectives.

The amount of income you receive will rise or fall, depending on the performance of the portfolio.

Usually, the annuity company guarantees return of premium (ROP), which means that you won’t lose your initial investment. But if your portfolio doesn’t perform well, you may not earn any growth. On the other hand, if your portfolio performs well, you have the potential for greater gains.

This is different from a fixed annuity, which features a pre-set interest rate that doesn’t depend on the performance of investments.

Learn More About Fixed Annuities

How Does a Variable Annuity Work?

When you purchase a variable annuity, you will have a number of options for investing the funds in your portfolio. The options, or subaccounts, may include stock mutual funds, bond mutual funds, money market funds, stable income value mutual funds and other investments.

Pro Tip
You may be able to transfer your money among subaccounts. However, the annuity provider may charge a transfer fee.

With a deferred, variable annuity, there will be two phases, the accumulation phase and a payout phase. With deferred annuities, you begin receiving income payments at a later date. If your variable annuity is structured also as an immediate annuity, there will be no accumulation phase.

Learn More About Annuity Types

Accumulation Phase

During this phase, your contract can increase in value. You make an initial deposit or contribution to purchase the annuity. You can specify how you would like to invest your funds. Before deciding how to invest your money, you should carefully examine the prospectuses for the available options.

With some variable annuities, you also have a choice of investing your money in a fixed-interest account. That interest rate may change, but you typically will have a guaranteed minimum interest rate.

The following example shows how one person’s investment could be distributed among various sources of income.

Chart showing an investment example

Over time, your money will increase or decrease according to the performance of the funds in which it is invested. During the accumulation, you may be able to transfer funds between accounts without tax consequences. But the annuity company may charge you to make the transfers.

Pro Tip
If your contract allows, your survivors will receive all or some of your annuity’s value if you die during the accumulation period.
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Payout Phase

During this phase, also known as the distribution phase, you may receive your funds and any gains either as a lump-sum or as a stream of variable payments. You can designate how long the payments will last. They may be for a period of years or an indefinite period, such as your life or the lives of you and your spouse or beneficiary.

Depending on your contract, you may also be able to select fixed payments or adjustable payments that will change, depending on the performance of your investment portfolio.

Variable Annuity Pros and Cons

As with any investment, the benefits and risks of variable annuities should be weighed when considering whether to invest. These annuities carry the promise of higher returns than fixed annuities. But, according to the Financial Industry Regulatory Authority, they also come with risks that warrant caution.

Pros
  • Possible Inflation hedge – If your investment portfolio performs well, you have the potential to see an increase in your payments, enabling you to better keep up with inflation.
  • Tax deferral – You don’t pay taxes on earnings until you take the money out of the annuity.
  • Initial investment protection – Usually the annuity company will guarantee you will have access to the money you invested, even if you make no interest if your portfolio does poorly.
  • Death benefit – If you die before you start receiving payments, your beneficiary will receive a payout from the annuity company.
  • Payments for life – You have the option of receiving payments for the rest of your life, even if your portfolio performs poorly and you exhaust your principal investment. You may have to pay extra for this option.
Cons
  • No guaranteed return – Unlike fixed and indexed annuities, there is no guarantee that you will earn interest on your investment. If your investment portfolio performs poorly, it will affect the value of your annuity.
  • Taxed as income – When you withdraw your money, the earnings are taxed as income, not at the more favorable capital-gains rate.
  • Complexity – Because they can be complicated, some investors may become confused about the provisions of variable annuities. This has led to what regulators say are questionable sales practices making variable annuities a leading source of investor complaints to the (FINRA).
  • Surrender charge – If you take some or all of your money out of your annuity earlier than the contract allows, you will have to pay a surrender or withdrawal charge. This charge can be as high as 10 percent early in the contract. Some annuities allow you to withdraw small amounts – typically 10 percent or less – annually.
  • Mortality and expense risk charge – This is the charge to cover guaranteed death benefits, guaranteed income for life or guaranteed caps on administrative charges. These fees can be 1.2 percent or more a year.
  • Administrative Fees – These cover record keeping and other administrative costs.
  • Sales commission – The agent who sold you the annuity may receive compensation for the sale.
  • Underlying fund expenses – These cover expenses of the subaccounts in which your money is invested. This can be more than 1 percent a year.

Free Look Period

Most variable annuity contracts have a “free look” period. It’s a test run on the annuity for you to determine if it’s right for your situation.

This is a time of 10 or more days in which you can cancel your contract without paying surrender fees. If you decide to terminate the contract, your premium will be returned to you. The amount may be affected by the performance of your investments during the free look period.

Questions About Variable Annuities

Can you lose money in a variable annuity?
Because variable annuities are tied to the stock market, you can lose money in a variable annuity. For this reason, fixed annuities are a safer product.
Are variable annuities protected from creditors?
States provide varying degrees of protection from creditors for variable annuities. Some offer full protection, and others offer none. For example, California’s statute claims protections for annuities are the same as for life insurance cash value “as long as an annuity is deemed insurance and not an investment.” This excludes variable annuities, which are classified as securities.
What is a group variable annuity?
A group variable annuity contract is a vehicle for companies that offer 401(k) and other retirement plans. These contracts are offered by insurance companies and are alternatives to mutual fund plan providers.
Who should buy a variable annuity?
People with the objective of capital appreciation and higher risk tolerance should buy variable annuities. These products are not suitable for people close to retirement or those who want guaranteed income.
What is a GMIB?
A guaranteed minimum income benefit, or GMIB, is a rider that protects variable annuity holders from the market risk inherent in these products. GMIBs guarantee a minimum monthly payment that is not affected by market performance.
Please seek the advice of a qualified professional before making financial decisions.
Last Modified: October 23, 2020

10 Cited Research Articles

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