What Is a Variable Annuity?

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Annuities have become an increasingly popular option for people who want to diversify their retirement funds. With an annuity, you make investments and then receive money in a series of payments that could last the rest of your life.

With a variable annuity, the value is based on the performance of its underlying investments, which sets it apart from other annuity types. Variable annuities might be a good option if you want a tax-deferred financial product with growth potential in your retirement portfolio.

What Is a Variable Annuity?

A variable annuity is a contract between you and an insurance company in which the insurer agrees to make periodic payments. These may begin either immediately or at some future date. You can buy a variable annuity contract by making a single purchase payment or a series of payments, according to the U.S. Securities and Exchange Commission, which regulates annuities.

The value of your variable annuity depends on the performance of your investment options. These typically include mutual funds that have money in stocks, bonds and/or money market instruments.

How Does a Variable Annuity Work?

Variable annuities typically have two phases: the accumulation phase and the payout phase.

Accumulation Phase

The accumulation phase is when you make payments into the account. These payments are called premiums, and after deducting fees, the insurance company divides them among your sub-accounts. Each sub-account contains a portfolio of investments.

The investment options generally consist of money market funds and stocks and bonds held within mutual funds. Some also give you the option of putting a portion of your premiums into a fixed-rate sub-account. This type of account pays a minimum guaranteed rate of interest.

You choose your investments for your sub-accounts from the selection provided in the annuity prospectus. The values of your sub-accounts rise and fall as the values of the investments rise and fall. Growth is tax-deferred, so you don’t pay tax on the money until you withdraw it.

Your money is essentially locked in during the accumulation phase. Although you can withdraw it, along with any gains you’ve earned, you’ll usually have to pay surrender charges. If you’re younger than 59.5 years old, you’ll also pay a tax penalty.

Payout Phase

After the accumulation phase, you can begin drawing funds from your annuity investments. This process is called annuitization. You’ll likely have several payment options, such as monthly payments for a specific number of years or for the rest of your life. The payments might vary from one payment period to the next, as the value of your sub-accounts rise and fall with the markets.

Benefits of Variable Annuities

Variable annuities have unique benefits that can make them a good choice for your retirement portfolio.

• Potentially higher returns compared to fixed annuities: Fixed annuities pay you a guaranteed minimum interest rate. That rate might be significantly lower than the gains you can earn over time with your money invested.
• Choice of investments: Variable annuities typically give you a range of investments to choose from. This allows you to build a diverse portfolio and balance potential gains with the level of risk you’re comfortable with.
• Tax-deferred growth. Similar to an individual retirement account or 401(k), your money grows tax-free in your variable annuity sub-accounts.

Risk of Variable Annuities

Variable annuities are investments, and as such, they have some risks you should be aware of.

• Volatility risk: Market volatility can reduce not only your gains, but also your principal — the premiums you paid into your sub-accounts.
• Fees: You’ll usually pay more fees, such as mortality and expense risk fees, with a variable annuity than with other types of investments.
• Limited liquidity: Variable annuities have “surrender” periods lasting several years after you purchase the contract. If you withdraw some or all of your money before the surrender period ends, you’ll pay a surrender charge. You could also be hit with a tax penalty.
• Inflation risk: If some of your investments in the annuity have fixed interest rates that are lower than the inflation rate, the money may lose its buying power over time, even if the account balance grows.

Types of Variable Annuities

You can choose between two different types of variable annuities, based on the payout schedule that best aligns with your investment goals.

Deferred Annuities

Deferred annuities are contracts you typically purchase years before retirement. You pay premiums during the accumulation phase and defer any payouts to some time in the future — typically, when you begin retirement.

Immediate Annuities

Immediate annuities, on the other hand, have no accumulation phase. You make a lump-sum payment when you purchase the contract and receive fixed payouts that can begin in as few as 30 days.

These payouts must begin within a year, according to the financial services company Thrivent. Immediate annuities are a better choice for those who are close to retirement or who’ve already retired.

Comparing Variable Annuity vs. Buy-and-Hold Strategies

Investing with a variable annuity insurance contract is different than long-term investing in securities like stocks, bonds and mutual funds.

Definition of Buy-and-Hold Strategy

Buy-and-hold investing is a long-term strategy where you purchase an investment with the intention of holding it for the long term. It’s the opposite of market timing — when an investor buys and sells securities according to what they think the market is going to do in the short term.

Buy-and-hold investing can apply to many different types of assets, including stocks, bonds, mutual funds and exchange-traded funds.

Pros and Cons of Each Approach

Variable annuities are long-term investments that provide many of the same benefits as long-term investments in stocks, bonds and funds — the very types of assets you might hold in your annuity sub-accounts. But they different in important ways.

Pros and Cons of Variable Rate Annuities

Pros

• Growth potential: Money in sub-accounts is invested, allowing for potential growth over time. Gains are reinvested, providing the benefits of compounded returns.
• Tax advantages: Gains are tax-deferred, so you don’t pay taxes on them until you begin receiving payments.
• Retirement income: Provides a source of retirement income that varies based on sub-account values.
• Death benefit: Typically includes a death benefit, so heirs receive money if the payout period hasn’t ended.

Cons

• Uncertain returns: Returns aren’t guaranteed and depend on the performance of the investments in sub-accounts.
• Liquidity issues: Cannot be sold on the open market. Liquidation may come with surrender charges and tax penalties, while exchanges can be complex.
• High fees: Often involves higher fees compared to buy-and-hold assets like stocks, bonds and mutual funds.

Pros and Cons of Buy-and-Hold Investing

Pros

• Ease of management: Long-term investments in stocks, bonds and mutual funds are set-it-and-forget-it strategies, unaffected by market volatility.
• Flexibility: You can easily add or remove investments from your portfolio.
• Compound gains and dividends: Investments grow through compound gains. Some assets provide dividends that can serve as retirement income.

Cons

• Risk of loss: All money is at risk, as holding investments long term mitigates risk but doesn’t eliminate it.
• Mutual fund fees: Funds charge fees called expense ratios, and some also charge fees when buying or selling.
• Tax implications: You may owe capital gains tax on gains from trades made by fund managers within mutual funds. Dividends are usually taxable, even if reinvested.

Which Option Fits Your Goals?

For many investors, the choice is both vs. either-or.

For example, you might consider focusing on buy-and-hold tax-deferred investing in stocks, bonds and mutual funds within individual retirement accounts and 401(k)s. This might be the case especially if you get matching contributions from your employer. The accounts are tax-advantaged, and you won’t have to pay the high fees associated with variable annuities.

Once you’re maxing out these contributions, a variable annuity might be a good next step.

If your risk tolerance is higher, and you aren’t concerned about tax incentives, you can buy and hold individual stocks, bonds and funds. With the added risk comes the potential for higher gains.

Variable Annuity vs. Buy-and-Hold at a Glance

How To Buy a Variable Annuity

Before you set out to buy a variable annuity, research all of your options carefully. You should make sure it’s the best type of investment for your retirement timeframe and your overall financial situation.

1. Use an annuity comparison tool to learn about the different annuities and providers.
2. Contact a financial advisor, whether through an investment brokerage or an insurance company. They’ll help you select the variable annuity that best meets your needs.
3. Do your homework before you commit. You can screen providers through rating sites like A.M. Best. For the annuity itself, read the prospectus thoroughly to make sure you understand fees, how your money will be invested, what to expect from payouts and how the death benefit works.
4. Fill out the application.
5. Pay your premium with a cash payment or transfer from another account.

Costs Associated With Variable Annuities

Fees can make variable annuities an expensive way to invest, so it’s important to understand what you’re paying. Here are some of the fees you can expect:

• Mortality and expense fees: Charged as a percentage of the value of your annuity to offset the provider’s risk. They usually range from 1.15% to 1.85% per year, according to Morgan Stanley.
• Administrative fees: Up to 0.60% to service the annuity and sub-accounts.
• Annual contract maintenance fee: Applicable for high-value contracts.
• Management fees on sub-account holdings: Usually ranging from 0.70% to 2.73% per year.
• Surrender charge: Can be 7% to 9% for liquidation during the surrender period.

To see how fees might impact your annuity, consider this example of a $25,000 annuity with the following fees:

• $287.50 for mortality and expense fee (1.15%)
• $150 for administrative fee
• $175 for sub-account investment fees (0.70%)
• Total: $612.50 for just one year

Vance Cariaga contributed to the reporting for this article.

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