What Is A Variable Annuity?
A variable annuity is a contract between you and an insurance company. In exchange for your premium payments, the insurance company agrees to invest your money in a variety of subaccounts, which are similar to mutual funds.
A variable annuity is designed to provide a stream of income during retirement, offering some similarities to traditional annuities but with additional investment options.
The value of your annuity will fluctuate based on the performance of the subaccounts you choose. This means that you have the potential for higher returns than with a fixed annuity, but you also have the risk of losing money if the market declines.
How Does Variable Annuity Work? Example
Let's illustrate how a variable annuity works with a simple example:
John decides to invest $100,000 in a variable annuity offered by an insurance company.
The insurance company offers various sub-accounts, similar to mutual funds. John allocates his $100,000 across different sub-accounts based on his risk tolerance and investment goals.
- Sub-Account A: 40% ($40,000)
- Sub-Account B: 30% ($30,000)
- Sub-Account C: 30% ($30,000)
The performance of each sub-account is tied to the underlying investments (e.g., stocks, bonds). If Sub-Account A performs well, its value increases; if it performs poorly, its value decreases.
While the annuity grows, John's investment gains are not immediately subject to taxes. This allows his money to potentially grow faster compared to taxable investments.
Throughout the annuity's life, John incurs costs and fees, including management fees for the sub-accounts and administrative fees.
After several years, John decides to retire and begins the income phase. He can choose between two options:
- Annuitization: John chooses to convert his annuity into a guaranteed income stream for the rest of his life. The amount he receives each month is determined by the value of the sub-accounts at the time of annuitization.
- Systematic Withdrawals: Alternatively, John decides to take systematic withdrawals based on his financial needs, but this doesn't provide the same guarantees as annuitization.
If John passes away before annuitization, his designated beneficiary will receive a death benefit. The amount may be the contract's account value or a minimum specified amount, whichever is higher.
Pros And Cons Of Variable Annuity
Variable annuities come with both advantages and disadvantages. Let's explore the pros and cons of variable annuities:
Potential For Higher Returns
Tax Deferred Growth
Fees and Charges
Customizable Investment Options
Flexibility In Payouts
Variable annuities offer the potential for higher returns than other types of investments, such as fixed annuities or CD rates.
This is because your investment earnings grow tax-deferred and are not subject to market risk.
Earnings within a variable annuity grow tax-deferred, meaning you don't pay taxes on the gains until you make withdrawals.
This can potentially accelerate the growth of your investment.
Variable annuities provide a range of investment options in the form of sub-accounts.
Investors can tailor their portfolios based on their risk tolerance and financial goals.
During the income phase, you can choose between systematic withdrawals or annuitization for a guaranteed stream of income, offering flexibility to match your retirement needs.
In the event of your death, your beneficiary will receive the value of your annuity, minus any outstanding fees.
Variable annuities are subject to market fluctuations, and the value of your investment can go down based on the performance of the chosen sub-accounts.
There is no guaranteed return, and you could potentially lose money.
Variable annuities can be expensive, with various fees such as management fees, administrative charges, and mortality and expense risk charges.
These fees can reduce the overall returns on your investment.
Variable annuities can be complex financial products, making it challenging for some investors to understand all the terms and features fully.
Variable annuities typically have surrender charges, which are fees that you pay if you withdraw your money within a certain period of time.
These charges can be as high as 10% of your withdrawal amount in the first year, and they gradually decline over time.
Fees And Charges Associated With A Variable Annuity
Variable annuities typically have a number of fees and charges associated with them, including:
- Sales charges: Variable annuities may have upfront sales charges, which are fees that you pay when you purchase the annuity. These charges can be as high as 7% of your investment amount.
- Mortality and expense risk (M&E) charges: M&E charges are fees that are used to pay for the insurance company's costs of providing death benefits and other guarantees. These charges can be as high as 1.5% of your investment amount per year.
- Investment management fees: Variable annuities have investment management fees, which are fees that are charged to cover the costs of managing the subaccounts. These fees can range from 0.5% to 2% of your investment amount per year.
- Other fees: Variable annuities may also have other fees, such as administrative fees, contract maintenance fees, and rider fees. These fees can vary depending on the specific annuity contract.
It is important to carefully consider all of the fees and charges associated with a variable annuity before investing. These fees can have a significant impact on your investment returns over time.
Variable vs Other Types Of Annuities
Variable annuities offer the potential for higher returns than other types of annuities, but they also have more risk. If the market declines, the value of your variable annuity can go down. Fixed annuities and indexed annuities have less risk, but they also offer lower potential returns.
Here's a short comparison between them:
Type of Annuity
How it Works
Guarantee you a fixed interest rate for a set period of time
Invest your money in a variety of mutual funds. The value will go up and down with the stock market
Invest your money in a stock index, such as the S&P 500. The value will go up and down with the stock market
You pay a lump sum of money and start getting an income stream immediately
start getting an income stream at a later date, such as when you retire
The best type of annuity for you will depend on your individual circumstances and goals.
If you are looking for a safe and secure investment, a fixed annuity may be a good option. If you are looking for some growth potential, but also want a guaranteed minimum return, an indexed annuity may be a good option.
If you need a guaranteed income stream, an immediate annuity may be a good option. If you want to grow your money tax-deferred until you need it, a deferred annuity may be a good option.
Purchase Variable Annuities: Things To Consider
Investing in variable annuities requires careful consideration due to their complex nature and associated costs. Here are some important things to consider before investing in variable annuities:
- Your age and risk tolerance: Variable annuities are not suitable for everyone. If you are nearing retirement or have a low risk tolerance, you may be better off with a fixed annuity or another type of investment.
- Your investment goals: Variable annuities can be a good way to grow your money over time and create a guaranteed income stream in retirement. However, they are not a good investment if you are looking to withdraw your money soon.
- Your financial situation: If you have other debt, such as credit card debt or student loans, it is important to pay this debt off before investing in a variable annuity.
- The fees and charges associated with the annuity: Variable annuities typically have a number of fees and charges associated with them, as described above. It is important to carefully consider all of the fees and charges associated with a variable annuity before investing.
- The investment options available: Variable annuities offer a variety of investment options, including stocks, bonds, and mutual funds. It is important to choose investment options that are appropriate for your risk tolerance and investment goals.
- Comparison with Other Retirement Investments: Compare variable annuities with other retirement investment options, such as IRAs and 401(k)s, to determine which best fits your financial goals and tax strategy.
- The surrender period: Variable annuities typically have a surrender period, which is a period of time during which you will pay surrender charges if you withdraw your money. It is important to understand the surrender period before you invest in a variable annuity.
- The riders available: Variable annuities may offer optional riders, such as living benefit riders, which provide certain guarantees or enhanced benefits. Assess the costs and benefits of these riders to determine if they align with your needs.
Annuity Payout Options: Understand the available payout options during the income phase, such as annuitization or systematic withdrawals, and choose the one that best meets your retirement income needs.
Financial Strength of the Insurance Company: Variable annuities are backed by the insurance company issuing the annuity. It's essential to choose a financially stable and reputable insurance company to minimize counterparty risk.
No, variable annuities are not guaranteed by the government. They are backed by the financial strength of the issuing insurance company.
Surrendering or canceling a variable annuity may involve surrender charges and tax consequences. Contact your insurance company for the appropriate process.
Yes, variable annuities usually allow you to transfer funds between the available sub-accounts.
Yes, the value of a variable annuity can go down if the underlying investments perform poorly.