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).
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.
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.