Variable Annuity Explained: How It Works, Types, and Examples
Summary:
Variable annuities are investment products that provide a fluctuating income stream based on the performance of underlying investments. This article explores how variable annuities work, their benefits and risks, and the key differences between variable and fixed annuities. We’ll also cover how to weigh the pros and cons of a variable annuity to help you make an informed decision.
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What is a variable annuity?
A variable annuity is a type of insurance contract that allows individuals to invest their funds in a portfolio of sub-accounts that resemble mutual funds. The income you receive from a variable annuity can increase or decrease depending on the market performance of the investments within those sub-accounts.
Annuities, in general, are designed to provide a consistent income stream, often used for retirement. Investors can choose between variable and fixed annuities, depending on their risk tolerance and income goals.
Fixed annuities offer guaranteed payments but typically provide lower returns. In contrast, variable annuities offer the potential for higher gains but come with the risk of losses due to market fluctuations.
How does a variable annuity work?
Variable annuities operate through a contractual agreement between the investor and an insurance company. Here’s a simplified breakdown of how they work:
- Investment Phase (Accumulation): The investor makes payments, either as a lump sum or in installments, to the insurance company. These funds are invested in a selection of sub-accounts, chosen by the investor, which function similarly to mutual funds.
- Payout Phase: At a pre-determined point (often retirement), the insurance company begins to make regular payments to the investor. The amount of these payments fluctuates based on the performance of the underlying investments.
Types of variable annuities
There are two primary types of variable annuities: deferred and immediate.
- Deferred Variable Annuities: These are typically used for retirement savings. Payments to the investor begin at a future date, allowing the invested funds to grow over time.
- Immediate Variable Annuities: These start making payments to the investor immediately after the account is fully funded, making them a suitable option for those who want immediate income.
Both types can be customized with additional features or riders, such as a guaranteed minimum income benefit, which helps mitigate some of the risks associated with market volatility.
Variable annuities vs. fixed annuities
One of the most important decisions when purchasing an annuity is choosing between a variable and a fixed annuity. Here’s a comparison:
- Fixed Annuities: Provide a guaranteed, predictable payment amount, with the insurance company bearing the investment risk.
- Variable Annuities: Offer the potential for higher returns but also introduce the risk that payments may decrease if the underlying investments perform poorly.
Comprehensive examples of variable annuities in action
Variable annuities can be difficult to understand in theory, so let’s look at a few real-world examples of how they work in practice.
Example 1: Retirement planning with a deferred variable annuity
Consider a 50-year-old investor named Sarah who is planning to retire at 65. She has maxed out her 401(k) and IRA contributions and is looking for additional tax-deferred investment opportunities. Sarah chooses a deferred variable annuity, investing a lump sum of $100,000. Over the next 15 years, her funds are invested in a portfolio of sub-accounts that include U.S. stock and bond funds.
By the time Sarah reaches 65, her investment has grown to $180,000, thanks to favorable market conditions. She chooses to start receiving monthly payments based on the current value of her annuity. If the investments continue to perform well, her payouts could increase over time. However, if the markets take a downturn, the payments could decrease, leaving Sarah with less income than anticipated.
Example 2: Immediate variable annuity for guaranteed income
John, age 70, has recently sold his business and is looking for a way to ensure a steady income stream during his retirement years. He chooses an immediate variable annuity, investing $200,000. Since he needs the income right away, the payments start immediately.
The value of John’s payments fluctuates depending on the performance of the sub-accounts he invested in. Some months, he receives higher payouts due to strong market performance, while in others, his payouts may decrease if the market takes a hit. John appreciates the flexibility and potential for growth, but he understands the risk of lower payments.
How to choose the right variable annuity
Choosing the right variable annuity can be a complex decision, especially with so many options available. Here are some factors to consider:
- Your risk tolerance: Variable annuities are riskier than fixed annuities because their value fluctuates with the market. Investors with a high risk tolerance who can handle market volatility may benefit more from a variable annuity.
- Your retirement goals: If you’re using a variable annuity to supplement other retirement savings, it can be a good choice for long-term growth. However, if you need guaranteed income, you may want to consider adding riders (like a guaranteed minimum income benefit).
- Fees and charges: Variable annuities often come with high fees. These include mortality and expense fees, administrative fees, and fees for additional riders. Carefully weigh these costs against the potential benefits.
Common variable annuity riders
Riders are optional features that you can add to a variable annuity to customize it according to your specific needs. Each rider comes at an additional cost, but they can offer benefits that help mitigate some risks.
Guaranteed minimum income benefit (GMIB)
One of the most popular riders for a variable annuity is the guaranteed minimum income benefit (GMIB). This rider ensures that the annuitant will receive a minimum level of income, regardless of how the underlying investments perform
. For example, if the market performs poorly and the value of your annuity drops, the GMIB guarantees a base level of income, so your payouts won’t fall below a certain threshold.
. For example, if the market performs poorly and the value of your annuity drops, the GMIB guarantees a base level of income, so your payouts won’t fall below a certain threshold.
Death benefit rider
A death benefit rider ensures that your beneficiaries receive a certain payout if you pass away before or during the payout phase. With this rider, your heirs could receive either the total contributions you made or the current value of the annuity, whichever is higher. This rider provides peace of mind, ensuring that your family will benefit from your investment even if market conditions aren’t favorable.
Conclusion
Variable annuities offer a flexible way to invest for long-term growth while providing the potential for a steady income stream in retirement. Although they come with market risk and high fees, the
Frequently asked questions
What are the fees associated with a variable annuity?
Variable annuities typically come with several fees, including mortality and expense risk charges, administrative fees, and investment management fees. Additionally, if you add riders for extra benefits, you will pay additional costs. It’s essential to understand all the fees before investing, as they can reduce your overall returns.
Can I withdraw money from my variable annuity before retirement?
Yes, you can withdraw money from a variable annuity before retirement, but doing so may incur surrender charges if it’s within the surrender period. Withdrawals made before age 59½ are also subject to a 10% IRS tax penalty, in addition to ordinary income tax on the withdrawal amount.
What happens to my variable annuity if I die before the payout phase?
Most variable annuities come with a death benefit rider, which ensures that your beneficiaries receive the total amount you invested or the current value of the annuity, whichever is higher. This feature can provide peace of mind, knowing that your investment will not be lost if you pass away before receiving your payouts.
Are variable annuities protected if the insurance company fails?
Variable annuities are not insured by the FDIC, but they are protected by state guaranty associations up to certain limits. If the insurance company that issued your annuity fails, the guaranty association in your state may step in to cover a portion of your investment.
How is a variable annuity different from an IRA or 401(k)?
Both variable annuities and retirement accounts like IRAs and 401(k)s offer tax-deferred growth, but they are different products. IRAs and 401(k)s are strictly retirement accounts, whereas a variable annuity is an insurance product that can be used for various investment goals. Additionally, annuities offer features like lifetime income streams and death benefits, which IRAs and 401(k)s do not provide.
Can I switch sub-accounts within my variable annuity?
Yes, most variable annuities allow you to switch between sub-accounts without incurring any tax liability. However, you should check with your provider for any restrictions or limitations that apply to changing investments within your annuity.
Key takeaways
- Variable annuities offer a potential for higher returns but also come with market risk.
- They provide tax-deferred growth, similar to retirement accounts like IRAs.
- High fees and surrender charges can erode potential gains.
- It’s essential to carefully read the prospectus before investing in a variable annuity.
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