What is a Variable Annuity?

A variable annuity is a type of annuity whose value is linked to the performance of an investment portfolio. Payouts from a variable annuity can increase if the portfolio does well and decrease if it loses money. Although variable annuities have higher return potential than fixed annuities, they do not offer guaranteed payouts.

A variable annuity is a type of investment vehicle that enables you to choose from a range of investments and ultimately pays you a fixed amount of income in your retirement, which is determined based on the performance of your chosen investments.

About Variable Annuity?

A variable annuity is an agreement between you and the annuity provider – generally an insurance company – in which you purchase the capability to receive an income stream for your life or set duration of time.

When you buy a variable annuity, the money you pay is allocated to an investment portfolio. You will have various choices to invest the money in your portfolio. These choices or subaccounts can have stocks, bonds, money market funds, stable income value mutual funds, and other investment options.

The amount of income you receive will increase or decrease depending on the portfolio’s performance.

How does a variable annuity function?

To start a variable annuity, you first need to purchase an annuity contract. You can make do with a lump sum deposit, by transferring money from another retirement account, such as a 401(k), or by funding the account periodically with small payments.

Then you have to determine how you wish to manage the contract. Variable annuities come in two types: the first is deferred variable annuities and second is immediate variable annuities.

In a deferred variable annuity, you delay receiving income payments from your contract until some time in the future, giving your balance more time to grow. In an immediate variable annuity, you start collecting payments right after you sign up and deposit your money.

You also have to determine how to invest the money. A variable annuity puts your money into an investment subaccount, which in a way resembles a mutual fund for an annuity. These sub-accounts invest your money in a pool of different assets such as stocks, bonds, and money market funds.

Your annuity provider will provide you with a list that details the investment focus of each sub-account. For example, you may be given a choice between a subaccount that is all stocks, one that is all bonds, and one that has a 50/50 mix of stocks and bonds. You decide how to divide your money into sub-accounts.

Advantages of Investing in Variable Annuity

  • Potential hedge against inflation: If your portfolio does well in the market, you may see a nice increase in your payouts. This will put you in a better position to keep up with inflation.

  • Initial Investment Protection: Ideally, the annuity company guarantees you the ace of your invested funds, even if your portfolio performs poorly and you have no interest.

  • Death benefit: If you die before receiving payments from your variable annuity plan, your nominee or beneficiary will receive a payment from the annuity firm.

  • Lifetime payments: Under such plans, you can get an option to receive payments for your entire life, even if you exhaust your principal investment. However, you may also have to pay a certain additional amount to avail of this option.

  • Tax Deferral – You don’t pay tax on the earnings until you withdraw the money from the annuity.

Disadvantages of Investing in Variable Annuity

  • No Guaranteed Returns: Unlike fixed annuity plans, variable annuities do not offer any guarantee that you will earn a profit or fixed interest on your investment. By chance your portfolio performs poorly; The valuation of your annuity will be affected.

  • Taxable under the head ‘income‘ – When you withdraw your money, the funds are considered as income, not at the more favorable capital-gains rate.

  • Mortality and expense risk charge – This is a charge to cover guaranteed death benefits, guaranteed income for life, or guaranteed caps on administrative charges. This fee can be 1.2% a year or more.

  • Administrative Fee – This covers record keeping and other administrative costs.

  • Sales Commission for Agent – The agent who sold you the annuity may obtain a commission for the sale.

  • Underlying Fund Expenses – This covers the expenses of the sub-accounts in which your money is invested. This can be more than 1% per year.

  • Complexity: Variable annuities are often complicated to understand. There are many investors who face problems in understanding its specific provisions. Other kinds of annuity schemes are relatively straightforward.

  • Surrender Charge: If you withdraw all or even part of your annuity money before the contract allows, you will have to pay a withdrawal or surrender charge.

Who Should Choose Variable Annuity?

Variable annuities are perfect for people like Tyson, who want more substantial potential payouts than fixed annuities offer — and who aren’t afraid to take some market risk.

A variable annuity can help diversify Tyson’s retirement investments and make his money tax-deferral. If he has already increased his annual 401(k) contributions it can be a great option.

This type of annuity is generally recommended for small investors with long time horizons and high-risk tolerance.

A variable annuity can benefit you the most if:

  • You have a long investment timeline. If you don’t plan to withdraw for years, you have time to wait for short-term losses.

  • You prefer to be in full control of your investment. Variable annuities deliver great customization and autonomy for self-sufficient investors. Variable annuities can also be attractive because you can choose your underlying stocks and bonds.

Accumulation and Payout Stages

With a deferred variable annuity, there will be two stages: an accumulation stage and a payout stage.

With a deferred annuity, you start receiving income payments at a later date. If your variable annuity is constructed as an immediate annuity, there will be no accumulation stage.

During the accumulation stage, the value of your contract may rise. You make an initial deposit or contribution to buy an annuity. You can specify how you want your funds to be invested. Before deciding how to invest your money, you should carefully examine the prospectus to explore your options.

With some variable annuities, you also have the option of investing your money in a fixed-interest account. That interest rate can vary, but you’ll usually have a guaranteed minimum interest rate.

Over time, your funds will grow or fall according to the performance of the funds in which they are invested. During the accumulation phase, you will be able to transfer funds between accounts without tax consequences. But the annuity company may charge you for the transfer.

During the payout phase, also known as the disbursement phase, you may receive your funds and any benefits as a lump sum or as a stream of payments. You can decide how long the payments will last. It can be for a period of years or for an indefinite period, such as your life or the lives of you and your spouse or beneficiary.

Depending on your contract, you may also choose fixed payments or adjustable payments that will vary based on the performance of your investment portfolio.

Death Benefits

All variable annuities contain a death benefit. If the contract is not annuitized, the insurer will pay the death benefit to the annuitant owner or the beneficiary named on the contract after the death of the annuitant.

The death benefit beneficiary is guaranteed the premium or present value of the contract, whichever is higher, minus any withdrawals and fees. The standard death benefit is available at any cost above the contract’s mortality and expense charges. It allows your beneficiary to receive the present value of the contract.

Many insurance companies have created new death benefits with additional guarantees. These options may include locking in investment performance at a specific time or guaranteeing a minimum periodic increase in the death benefit.

As per a consumer bulletin from the U.S. SEC: “The objective of a stepped-up death benefit is to ‘lock in’ the performance of your investment and to avert a later fall in the value of your account from deteriorating the amount that you consider to leave to your heirs.” Any enhanced annuity death benefit is optional, carries a slightly higher fee than the standard death benefit, and may have age limits. For example, insurance companies may not sell you a step-up or advanced death benefit if you are over age 69 or 75.

Keep in mind that the beneficiary of your annuity will also inherit your liability to pay income tax on the difference between what you paid for your annuity and what it’s worth when you die.

Free look period

Most variable annuity contracts include a “free look” period. There is a test run on an annuity for you to determine whether it is right for your situation.

This is a period of 10 or more days in which you can cancel your contract without paying a surrender fee.

If you determine to end the contract, your premium will be reimbursed to you. The amount may be affected by your investment performance during the free look period.

Variable Annuity vs. Fixed Annuity

Fixed annuity assures that you don’t lose money and pays a fixed return every year as promised by the annuity company. This makes fixed annuities safer than variable annuities, but also has less upside. You may not lose money and you may not always make some money every year, but you may not see huge gains during the good years either.

For instance, as of August 2020, fixed annuity interest rates vary from approximately 1.0% to 3.60%, as per Blueprint Income, a fixed annuity marketplace. Variable annuities, on the other hand, are limited only by market gains, which have historically averaged 10% per annum.

Which Makes More: Variable Annuities or Fixed Annuities?

There is no exact explanation for this. While variable annuities have greater potential for earnings, since their interest rate rises and fall with their underlying investments, they can lose money. They also mess with fees, which can cut into profits. Fixed annuities typically earn a low, fixed rate. Look carefully at your options when selecting an annuity.

Variable Annuity vs. Index Annuity

Index annuity falls between fixed annuities and variable annuities. With an index annuity, your return is based on a market index, such as the S&P 500. This allows you to benefit from stock market gains, as well as lose money if the markets decline, as with a variable annuity. But unlike variable annuities, index annuities always limit both your potential gains and losses.

Your annuity company might say that in bad years, for example, the worst your index annuity can do is return 0%, so you’ll always break even. In return, they may set a cap so that you can earn at most 10% in a good year.

A variable annuity can make more money during a good year, but it’s also possible you could lose money in a bad year—and expense riders will be needed to limit your losses.

The bottom line

Before purchasing a variable annuity, investors should read the prospectus carefully to try to understand the costs, risks, and formulas used to calculate investment gains or losses. Annuities are complex products, so they are easier said than done.

Keep in mind that between the numerous fees — such as investment management fees, mortality fees, and administrative fees — and charges for any additional riders, the cost of a variable annuity can add up quickly. It can adversely affect your returns in the long run compared to other types of investments.

FAQs- About Variable Annuities

1. Are variable annuities safe from creditors?

Answer: States provide varying degrees of protection from creditors for variable annuities. Some provide complete protection, while others offer none. For example, California statute claims that protection for an annuity is the same as for life insurance cash value “so long as the annuity is considered insurance and not an investment.” This excludes variable annuities, which are categorized as securities.

2. What is GMIB?

Answer: The Guaranteed Minimum Income Benefit, or GMIB, is a rider that protects variable annuity holders from the market risk inherent in these products. GMIB guarantees a minimum monthly repayment that is not affected by market performance.

3. Who should prefer a variable annuity?

Answer: People with the objective of capital growth and high-risk tolerance should buy a variable annuity. These products are not suitable for those nearing retirement or those seeking guaranteed income.

4. Can you lose funds in a variable annuity?

Answer: Because variable annuities are tied to the stock market, you can lose money in variable annuities. For this reason, a fixed annuity is a safe product.

5. What is Group Variable Annuity?

Answer: Group variable annuity contracts are a vehicle for companies that offer 401(k) and other retirement plans. These contracts are provided by insurance companies and are alternatives to mutual fund scheme providers.