Variable annuities are a type of annuity contract with a wide range of investment options. Variable annuities can offer higher returns than other more conservative investment contracts, like fixed and indexed annuities — but also come with the risk of losing money during a financial downturn. Variable annuities are considered securities, so they’re regulated by the SEC and FINRA in addition to state insurance commissioners. [1]
What is a variable annuity?
A variable annuity is a contract between you and an insurance company that’s used as an investment tool in order to generate a stream of income in the future. When you fund your annuity, your money is tied to the performance of underlying subaccounts. Different insurers give you different options for how to invest your money — you can often choose from mutual funds that invest in stocks, bonds, or money market instruments. [2]
Deferred variable annuities
Many variable annuities are deferred — which just means you won’t receive payments right away. You’ll choose when your payments will start and how long they’ll last. This choice will likely be a factor in the investments you choose, too.
Immediate variable annuities
As with most annuities, you can also structure your variable annuity such that you begin to receive payments immediately, while the bulk of your premium is still invested through your insurer. This option generally requires a large lump-sum payment up front. Most variable annuities are deferred, but immediate variable annuities are still available, depending on the insurer.
Learn more about immediate annuities
How do variable annuities work?
A variable annuity works similarly to other types of annuities in that you pay premiums toward your contract, during the accumulation phase. In return, once the accumulation period ends, you start receiving payments from your annuity on a regular basis — during the annuitization phase.
What makes variable annuities unique is the wide array of investment options you can choose from. Your funds will grow or shrink based on the performance of the underlying investments.
“When [consumers] invest in a variable annuity, the [insurance] company will use that money to purchase stocks,” says Tony Boyden, learning and development partner at Zinnia. “This money has no cap or floor — if the stock market goes up or down, so will the annuity.”
Premiums
Your premiums are the payments you contribute in order to fund your annuity. You can choose how much you want to put down as an initial payment, or how much you want to pay in installments over time.
Accumulation period
If you choose a deferred annuity, you can continue making payments during the accumulation period — the period of time your money is invested through your subaccounts. Accumulation periods usually last between three and 10 years, but the options will depend on your insurance company.
You can choose how you want your money to be invested based on your insurer’s offerings. Some insurers also allow you to set aside a portion of your premiums in a fixed account, which pays a fixed rate of interest set by the insurer. [3]
During the accumulation period, you may also be able to transfer funds between one investment option and another, but it depends on your insurance company, which may charge a fee for transfers. [4]
Annuitization or payout phase
Annuitization is when you start to receive payments from your annuity, usually between three and 10 years after you sign your contract. Most often, these income payments are paid out as a series of installments on a monthly or annual schedule. You can choose how long your payout phase lasts — for example for 10 years, 20 years, or for life.
The payment amount you receive could vary based on the performance of the underlying investments, but some insurers allow you to set a fixed minimum payment as well.
Surrender period & other fees
The surrender period is the length of time before you can withdraw funds from or sell your annuity without incurring a penalty fee. Your insurer will set the surrender period for your policy, but most last between three and 10 years. Some annuities have gradual surrender fees, too, where you’d pay a higher penalty for withdrawals in the first year of your contract than you would in three or five years.
Management fees can also be steep for variable annuities — when you make payments, the amount of money that’s actually invested is often less than what you paid due to fees and commissions.
Variable annuities also often require you to pay a mortality and expense risk charge, which insurers use to buffer against losses. This expense is typically around 1% of your account value, which can also cut into your returns.
Tax implications
Like other annuities, variable annuities are tax-deferred, so you won’t pay taxes on your earnings until you start taking withdrawals from your account. On the other hand, if you need to make withdrawals before you reach age 59 ½, you’ll incur an additional tax penalty. This penalty is similar to tax regulations on other retirement accounts. [5]
What are the pros & cons of variable annuities?
Variable annuities offer you more control over how your premiums are invested and have high growth potential, but they also expose you to more market volatility than other types of annuities. They also don’t offer any principal guarantees.
Pros
Customizable investments. Variable annuities let you choose how your funds are invested, so you have more flexibility and freedom of choice than with other types of annuities.
High growth potential. Variable annuities don’t come with caps on your earnings, so they have higher potential for growth than other types of annuities, like fixed or indexed.
Tax-deferral. You won’t pay taxes on gains until the payout phase. Plus, any interest you earned is also tax-deferred.
Cons
High fees. Variable annuities can have steep commissions, while investment management and administration fees can add up and detract from your earnings.
High investment risk. Variable annuities don’t offer a guaranteed return on your investment, so you could lose money.
Complex contracts. Variable annuities are complex financial products that can be difficult to understand without the help of an advisor.
What should you consider before buying a variable annuity?
A variable annuity is a hands-on investment product, so it’s important to fully understand the specific terms of the contract and your insurer’s guidelines before purchasing. You should also consider how a variable annuity fits into your overall financial plan and investment goals.
Your age
If you’re close to retirement age, and you’re looking for more guarantees and less risk in your annuity contract, a variable annuity is likely not the best fit for you. But if you don’t need a guaranteed income stream in the near future and you want to diversify your investment portfolio, this type of product could be a good fit for you.
Your investment goals
If you’re looking for an additional investment vehicle with the potential to convert to an income stream in the future, a variable annuity could fill that need. Since most variable annuities are deferred, they’re generally used for long-term investment goals.
Your risk tolerance
Generally speaking, variable annuities are best for those who have high tolerance for risk, since they don’t come with guaranteed minimum returns and there’s the possibility of losing money. If you have a lower risk tolerance, you may want to consider indexed annuities with guarantees, or fixed annuities instead.
Learn more about other types of annuities
Who should consider variable annuities?
If you want a long-term investment vehicle, you’re aware of the potential fees, and you’re comfortable with the investment risk, you should consider a variable annuity.
The type of annuity — or investment vehicle — that’s right for you will depend on your personal financial situation, as well as the factors listed above, so speaking with a financial advisor can help you make a choice that best fits into your overall financial plan.
