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Variable annuities carry the potential of higher returns than fixed annuities and can offer a hedge against inflation. Their payout is tied to the performance of an investment portfolio, which means there are risks, as well.
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.
Variable annuities produce income payments tied to the performance of an investment portfolio. This portfolio may contain several investment choices. The idea is to provide a potential hedge against inflation. But variable annuities also carry risks.
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 placed in an investment portfolio. The amount of income you receive will rise or fall, depending on the performance of the portfolio.
Usually, the annuity company guarantees you won’t lose access to your initial investment. But if your portfolio doesn’t perform well, you may not make any interest. 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.
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 may include stock funds, money market funds, bonds, mutual funds and other securities.
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.
During this phase, your money accumulates or builds. You make payments to purchase the annuity. You designate where you what your purchase payments to be invested. 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 putting some of 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.
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.
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 choose if the payments will all be the same or they 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.
- 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.
- 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 usually 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 extra 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 contain what’s called a “free look” period. It’s sort of a test run on the annuity where you can try it out to see if it will work for you.
This is a time of 10 or more days in which you can back out of your contract without paying surrender fees. If you decide to terminate the contract, you will get your purchase payments back. The amount may be affected by the performance of your investments during the free look period.
10 Cited Research Articles
- Lankford, K. (2016, May). Variable Annuities: Guaranteed Income, With a Catch. Retrieved from https://www.kiplinger.com/article/retirement/T003-C000-S002-variable-annuities-guaranteed-income-with-a-catch.html
- Financial Industry Regulatory Authority. (n.d.). Variable Annuities: Beyond the Hard Sell. Retrieved from http://www.finra.org/investors/alerts/variable-annuities-beyond-hard-sell
- U.S. Securities and Exchange Commission. (n.d.). Variable Annuities. What You Should Know. Retrieved from https://www.sec.gov/files/sec-guide-to-variable-annuities.pdf
- National Association of Insurance Commissioners. (2017, December 6). Variable Annuities. Retrieved from https://www.naic.org/cipr_topics/topic_variable_annuities.htm
- Financial Industry Regulatory Authority. (n.d.). Variable Annuities. Retrieved from http://www.finra.org/industry/variable-annuities
- Josephson, A. (2018, July 16). Is a Variable Annuity a Good Idea? Retrieved from https://smartasset.com/retirement/is-a-variable-annuity-a-good-idea
- CNN Money. (n.d.). Ultimate Guide to Retirement. Annuities. Retrieved from https://money.cnn.com/retirement/guide/annuities_variable.moneymag/index.htm
- Investopedia. (n.d.). Variable Annuity. Retrieved from https://www.investopedia.com/terms/v/variableannuity.asp
- Murray, S. (2018, January 31). Getting the Whole Story on Variable Annuities. Retrieved from https://www.investopedia.com/retirement/variable-annuities-whole-story/
- Anspach, D. (2018, September 5). The Definition of a Variable Annuity. Retrieved from https://www.thebalance.com/what-is-a-variable-annuity-2389030