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What Is a Variable Annuity & How Does It Work?

April 21, 2022
8
min

A variable annuity is a contract between a buyer and a seller, sold mainly by insurance companies. Unlike other annuities, variable annuities are considered securities.

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A variable annuity lets investors turn the potential upside from investing in financial markets into an income stream that grows tax-deferred. Many also include a death benefit that can act as life insurance for the investor’s beneficiaries.

Retirees often use variable annuities to supplement Social Security or income from a 401(k) or an individual retirement account (IRA). Like most annuities, variable annuities let the investor take their payouts over a specific time period, or the rest of their life. Holders also can opt to collect a lump sum.

What is a variable annuity?

A variable annuity, like all annuities, is a contract between a buyer and a seller that’s sold mainly by insurance companies. But unlike other annuities, variable annuities are considered securities and are regulated at the federal level by the Securities and Exchange Commission. State insurance departments also oversee them. 

Individuals fund the annuity by making a single deposit or a series of premium payments. The annuity issuer begins delivering regular payouts either soon after the buyer opens their account, with an immediate annuity, or at a future date, with a deferred annuity.  

As the name suggests, the value of a variable annuity changes over the life of the contract. That’s because the annuity is an investment tied to the stock and other markets, generally through mutual funds. Fluctuations in the portfolio’s value have an impact on the annuity owner’s returns. Payments can increase if the portfolio performs well and decrease if it declines. A variable annuity can lose money and does not guarantee investors a specific payout.

This is also true for IRAs and other traditional strategies that invest in financial markets. 

How do variable annuities work?

Buyers of variable annuities choose the portfolio their annuity invests in, typically mutual funds that include stock, bond, money market, and other offerings. These investments are known as subaccounts. 

Variable annuities differ from buying a mutual fund directly in several ways:

  • Variable annuities can provide an income stream of periodic payments.
  • Most provide a death benefit in which the insurance company makes a payment to the beneficiary when the holder dies. 
  • Income and investment gains grow tax deferred until money is withdrawn. 
  • Investors can transfer money within the subaccounts without paying tax on investment gains.
  • They are sold mainly by insurance companies.

Variable annuities, like other types of annuities, have an accumulation phase and a distribution phase. In the accumulation phase, the investor builds savings through regular contributions or a lump sum deposit. They select the annuity’s investment portfolio, time frame, and other details. Some variable annuities include selections that provide a guaranteed minimum fixed interest rate. 

In the distribution phase, the holder begins taking payments. Investors can receive either a lump sum or a regular income stream, in which the investment is broken down or annuitized into smaller payments. Investors may be able to choose between receiving a fixed payment amount, or one that varies based on the performance of the underlying investments.  

The amount of each payment depends, in part, on the time period over which the investor decides to receive payments.

The annuity grows tax deferred until the holder is ready for their distributions. If the annuity is funded with post-tax dollars, only the annuity’s investment gains are taxed. With IRAs and other tax-advantaged investments, the entire amount withdrawn is subject to federal income tax when the investor takes a distribution.

Investors must wait until age 59 ½ to take distributions without incurring a 10% tax penalty. Annuities generally don’t allow withdrawals once payments have started.

Variable annuity example

Investors can use an annuity calculator to estimate how a variable annuity might perform for them.

For instance, a 29-year-old makes a one-time after-tax investment of $10,000. The individual elects to begin receiving distributions at age 65. They select a portfolio that’s expected to return 7% a year. 

Given these parameters, the annuity would total $114,255 when the holder hits 65 and is ready to take distributions. The balance after paying taxes on the investment gains would be $91,319, according to an annuity calculator.

Fixed annuity vs. variable annuity

People often compare variable annuities with fixed annuities. But there are key differences between the two.

  • Type of product. Whereas variable annuities are classified as securities, fixed annuities are insurance products. As such, it is regulated by a state’s insurance commission but receives no federal oversight. 
  • Risk. A fixed annuity provides a guaranteed interest rate on their savings and protects the investor’s principal for the contract-determined time. The value of a variable annuity’s investment portfolios fluctuates and the annuities do not guarantee to return a set interest rate or to preserve the investor’s principal, as a fixed annuity does.
  • Potential returns. Fixed annuity interest rates as of March 2022 averaged 2.15% to 3.25% for investments ranging between two years and 10 years. Variable annuity returns are often similar to popular exchange-traded funds (ETFs) and index funds, at 8% to 10% a year, not including fees. 
  • Added costs. Fixed annuity sellers typically make money by paying holders a lower percentage than the company makes from investing the client’s money. This built-in profit to the seller can eliminate or limit the fees investors pay to own the annuity. Riders and other provisions, however, can add an annual average of 1.75% of the annuity’s value to the cost. Selling agents usually receive lower commissions with a fixed annuity than with a variable or other annuity type, further reducing costs to the buyer.
  • Terms. Buyers also usually find fewer terms and conditions with a fixed annuity, making them easier to understand. And because of their fixed nature, the holder knows how much money they’ll be getting and when.

The biggest difference between variable and fixed annuities is reflected in their names—one offers variable performance and the other offers fixed income. The choice between the two is personal, and hinges on an investor’s risk tolerance. Financial markets are unpredictable. While the S&P 500 index has returned an average of about 10.5% a year since 1957, the index declined about 5% in the first quarter of 2022. The decline damps a variable annuity’s performance for the quarter while a fixed annuity’s return would be unaffected.

Potential benefits and risks of variable annuities

Variable annuities offer potential benefits as well as some risks not available with fixed annuities or other types of investments.

Potential benefits of variable annuities

  • Returns. Variable annuities offer the possibility of high returns and income growth linked to financial markets, whereas other types of annuities may offer a fixed return.
  • Death benefit. Survivors often receive a guaranteed payout if the holder dies before all funds in the annuity are distributed; death benefits can also be structured based on market performance or the holder’s age at death.
  • Tax advantages. Variable annuities grow tax deferred and only an investor’s gains are taxed at withdrawal if they contribute with after-tax dollars. Traditional IRAs and other tax-advantaged accounts are fully taxed at withdrawal, because they’re funded with pre-tax dollars.
  • Unlimited contributions. There are no limits on contribution amounts, and they can supplement IRAs and other retirement savings plans that have contribution limits.
  • Lifetime income. Variable annuities can be structured to provide lifetime income via regular periodic payments rather than investor initiated withdrawals.
  • Creditor protection. Some states prevent variable annuities from being seized by creditors or a bankruptcy court.

Potential risks of variable annuities

  • Commissions. Annuity holders pay the agent who sells the contract a commission, which is often built into the price. Commissions can be as high as 10% of the contract’s value and are generally higher with a variable than a fixed annuity.
  • Fees. Variable annuity fees can average 2% to 4% of the portfolio’s value. Charges cover administrative fees, riders, and other special features. Mortality and expense risk charges cover guaranteed death benefits, payout options, and caps on other costs. Guaranteed minimum income benefits, long-term health protection, and principal protection can add more to the price tag.
  • Surrender charges. Investors who want to sell or withdraw money from their annuity before a stipulated time face a charge by the seller that can amount to 10% of the contract’s value in the first year.
  • Early withdrawal penalties. On top of what they pay the annuity seller, investors pay a 10% tax penalty to the Internal Revenue Service if they withdraw money before age 59 ½. 
  • Fund expenses. Mutual fund companies collect fees related to the offerings in a variable annuity’s subaccounts.
  • Investment risk. Variable annuities face the risks associated with tying an investment to the financial markets. These annuities can lose money if markets perform poorly.

The bottom line

Variable annuities allow investors to save tax deferred for a long-term goal such as retirement. Buyers can benefit when financial markets rise because variable annuities invest in mutual funds whose value can increase significantly over time. Holders can annuitize the distributions from their annuity so the payments last the rest of their life. These payments can be helpful in supplementing Social Security and other retirement income.

However, variable annuities do not guarantee the holder a specific return or the protection of the money they’ve invested. The return reflects the portfolio the holder chooses and fluctuates based on its performance. Commissions and fees are higher than with fixed annuities and other investments and can eat into the investor’s return.

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