What is a Variable Annuity?

A variable annuity is a contract which an insurance company sells. The contract provides future payments to the holder, based on the strength of the underlying securities of the contract. The insurer ensures a minimum payment but it could vary the rate of return on the underlying securities.

Those securities’ performance, usually mutual funds, specifies the size of the eventual annuity payment.

A variable annuity provides an array of investment choices. Like a variable annuity owner, the value of your investment will depend greatly on the performance of the investment options you choose.

Typically, the investment options for a variable annuity are mutual funds investing in stocks, bonds, money market instruments or some mixture of all three.

Each variable annuity is unique. Most include features that distinguish them from other insurance products and investment options.

  • There are insurance features for variable annuities

    For example, if you pass away before you start making the insurance company’s income payments, many contracts ensure that your beneficiary will receive at least a set amount.

    This is typically at least the amount that you paid in. It can also provide extra insurance features such as offering you a certain account value or making withdrawals set amount every year for the remainder of your life.

  • Tax-deferred variable annuities

    That means that you don’t pay any federal income taxes and investment gains from your annuity until you make a withdrawal, receive income payments or pay a death benefit. You can also transfer your money within a variable annuity from one investment option to another, without paying federal tax at the time of the transfer.

    However, you will pay tax on gains at ordinary federal income tax rates instead of lower capital gains rates when you withdraw your money.

    Under certain circumstances, the death benefit might not be subject to federal tax for the estate. Generally, tax deferment benefits can only outweigh the cost of a variable annuity if you keep it as a long-term investment.

  • Regular Income Payments

    Variable annuities allow you to receive regular income payments for a given period or the rest of your life (or your spouse’s life). This process of turning your investment into a stream of regular payments of income is known as annuitization.

    This feature protects from the possibility of outliving your assets.

How Do Variable Annuities Work?

A variable annuity has two phases: a phase of accumulation, and a phase of payout.

1. The Accumulation Phase

You make purchase payments throughout the accumulation phase, which you can allocate to a series of investment options.

For example, you might designate 40% of your purchase payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. The money you have allocated to each investment option of the mutual fund will increase or decrease over time depending on the performance of the Fund.

Furthermore, variable annuities often enable you to allocate part of your purchase payments to a set account. Unlike a mutual fund a fixed account pays a fixed interest rate.

The insurance company may periodically reset this interest rate, but will usually provide a guaranteed minimum (e.g. 3 percent per annum).

The Prospectus

Your most important source of information about investment options for a variable annuity is the prospectus. Request the prospectuses for investment options in the mutual fund. Before you allocate your purchase payments among the offered investment options, read them carefully.

You should consider a variety of factors regarding each fund option including the investment goals and policies of the fund, management fees and other expenses charged by the fund, the fund’s risks, and volatility, and whether the fund contributes to the diversification of your overall investment portfolio.

  • During the accumulation phase, you can generally transfer your money from one investment option to another without paying tax on your investment income and gains, although the insurance provider may charge you for transfers. 

  • If you withdraw money from your account during the early years of the accumulation phase, you will have to pay surrender costs.

  • If you withdraw money before the age of 59.5 you may have to pay a federal tax penalty of 10 percent.

2. The Payout Phase

You can receive your purchase payments plus investment income and gains (if any) as a lump-sum payment at the start of the payout phase or you may choose to receive them at regular intervals (usually monthly) as a stream of payments.

  • If you choose to receive a payment stream, you may be given several choices as to how long the payments last. You can choose to have your annuity payments last for a period you set (such as 20 years) or for an indefinite period (such as your lifetime or your spouse or other beneficiary’s lifetime) under most annuity contracts.

  • During the payout phase, your annuity contract may allow you to choose between receiving payments that are fixed in amount or payments that vary depending on the performance of the investment options for the mutual fund.

The amount of each periodic payment will, in part, depend on the period you select to receive payments. Be aware that certain annuities will not allow you to withdraw money from your account once you receive regular annuity payments.

Also, certain annuity contracts are structured as immediate annuities, meaning that there is no phase of accumulation and you will start receiving annuity payments immediately after you purchase the annuity.

Pros of Variable Annuities

1. Tax-Deferred

Variable annuities are increased tax-deferred, so you don’t have to pay taxes on any investment gains until you start earning income or making a withdrawal. That also applies to retirement accounts, such as traditional IRAs and, of course, 401(k)s.

2. Tailored Revenue Stream

The revenue stream can be tailored to suit your needs.

3. Guaranteed Death Benefit

If you die before the payout phase, you may get a guaranteed death benefit from your beneficiaries.

4. Protected

In an annuity, the funds are off-limits for creditors and other debt collectors. This is also generally true of retirement plans.

Cons of Variable Annuities

1. Risk

Variable annuities are riskier than fixed annuities because the underlying investments can be worthless.

2. Surrender Fees

You may face surrender fees if you need to withdraw money from the account due to a massive financial emergency. Any withdrawals you make before age 59 1⁄2 may also be subject to a tax penalty of 10 percent.

3. Heavy Fees

The expenditures of a variable annuity can quickly add up between the investment management fee, mortality fees, administrative charges for any additional riders. That can have long-term adverse effects on your returns compared to other types of investment.

4. Complex

Before buying a variable annuity, investors must read the prospectus carefully to try to understand the costs, risks, and formulas used to calculate investment gains or losses. Annuities are complicated products which can be said more easily than done.

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General Resources

Updated Investor Bulletin | U.S. Securities and Exchange Comission

What is an Annuity? | Investopedia

Understanding Variable Annuities | Morgan Stanley

Variable Life Insurance | Investor.gov

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