What is a Variable Annuity?
A variable annuity is a type of annuity contract whose value can fluctuate based on the performance of an underlying portfolio of sub accounts. These sub accounts operate similarly to mutual funds but lack ticker symbols for easy tracking.
Variable annuities differ significantly from fixed annuities, which offer a guaranteed return. Instead, they provide an opportunity for higher returns tied to market performance, albeit with a corresponding risk of potential losses.
Key Takeaways
- The value of a variable annuity depends on the performance of an underlying portfolio of sub accounts selected by the annuity owner.
- Fixed annuities offer guaranteed returns.
- Variable annuities present potential for high returns and greater income but come with the risk of account value reduction.
Understanding Variable Annuities
The value of a variable annuity hinges on two components: the principal amount paid into the annuity and the returns delivered by the underlying investments over time.
One prevalent type of variable annuity is the deferred annuity, often used for retirement planning. It offers regular income beginning at a future date. Immediate annuities, meanwhile, start paying income right away.
Variable Annuity Basics
An annuity can be purchased with either a lump sum or a series of payments. For deferred annuities, this phase is the accumulation phase. When the annuity owner initiates income payments, it enters the payout phase. Note that once income distribution begins, additional withdrawals may not be permitted.
Variable annuities serve as long-term investments due to withdrawal restrictions. Generally, one annual withdrawal is allowed during the accumulation phase; however, withdrawals during the surrender period often incur surrender fees. Also, early withdrawals before age 59½ may result in a 10% tax penalty.
Variable Annuities vs. Fixed Annuities
Variable annuities, introduced in the 1950s, serve as alternatives to fixed annuities, allowing investments in mutual funds offered by insurers. The benefit is the potential for higher returns and a larger income during the payout phase, but with the downside of market risk—which can lead to losses.
Variable Annuity Advantages and Disadvantages
Advantages
- Tax-Deferred Growth: Investment gains are not taxed until income is received or withdrawals are made, similar to retirement accounts like IRAs and 401(k)s.
- Tailored Income Streams: Adaptable to individual needs.
- Guaranteed Death Benefit: Beneficiaries receive a guaranteed payout if the owner dies before the payout phase.
- Protected Funds: Annuity funds are generally protected from creditors.
Disadvantages
- Higher Risk: Underlying investments might lose value.
- Surrender Fees: Early withdrawals can lead to hefty fees, particularly before age 59½, inclined with a 10% tax penalty.
- High Fees: Charges include investment management fees, mortality fees, administrative fees, and costs for additional riders—all accumulating to detract from overall returns.
What Is an Annuity?
An annuity is an insurance product promising future income based on funds invested by the owner. Post-purchase, the funds are invested until a pre-determined disbursement period, determined by the owner’s age.
Variable vs. Fixed Annuities Earnings
There is no definite answer. While variable annuities offer higher earning potential due to fluctuations with underlying investments, they might also incur losses and fees that eat into profits. Fixed annuities provide a lower but stable income, making it crucial to closely evaluate options when choosing an annuity.
Are Annuities FDIC-insured?
No, annuities aren’t insured by the Federal Deposit Insurance Corp. (FDIC). However, state guaranty associations provide some level of protection if the insurance company defaults.
The Bottom Line
Before investing in a variable annuity, it’s imperative to thoroughly review the prospectus to ascertain expenses, risks, and methods of calculating gains or losses. Keep in mind the array of fees that could cumulatively diminish long-term returns compared to other investment types.
Related Terms: annuities, deferred annuities, fixed annuities, immediate annuities.
References
- U.S. Securities and Exchange Commission. “Variable Annuities: What You Should Know”, Page 3 (Page 5 of PDF).
- U.S. Securities and Exchange Commission. “Variable Annuities: What You Should Know”, Pages 5–7 (Pages 7–9 of PDF).
- U.S. Securities and Exchange Commission. “Variable Annuities: What You Should Know”, Page 10 (Page 12 of PDF).
- U.S. Securities and Exchange Commission. “Updated Investor Bulletin: Variable Annuities”.
- Federal Reserve Bank of Chicago. “How Much Risk Do Variable Annuity Guarantees Pose to Life Insurers?”
- U.S. Securities and Exchange Commission. “Variable Annuities: What You Should Know”, Page 6 (Page 8 of PDF).
- Annuity.org. “Annuities”.
