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What Is a Variable Annuity Explained – Definition, Pros & Cons


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Annuities are among the oldest investment options – in fact they have centuries of history. Especially over the past century, fixed income annuity contracts have gained popularity with conservative investors as a safe means of growing their money on a tax-deferred basis.

But in the bull markets of the ’80s, a new type of annuity contract allowed investors to participate in the debt and equity markets and enjoy the benefits of annuities at the same time. These vehicles, known as variable rate annuities because of the variability of the returns realized, began in 1952 as a funding vehicle for pension plans. Originally started by the Teachers Insurance and Annuities Association – College Retirement Equity Fund (TIAA-CREF), these vehicles became more popular after the Tax Reform Act of 1986 closed many of the other tax loopholes that were available to investors.

Since then, they’ve grown into a multibillion dollar industry that is now regulated by insurance and securities agencies such as FINRA and the SEC, as well as state insurance commissioners.

How Do Variable Annuities Work?

Variable annuities can provide great returns, but they’re the riskiest type of annuity contract you can buy. Unlike fixed and equity indexed annuities, variable annuities do not guarantee your principal investment, interest, or other gains.

When you invest in a variable annuity, your money is allocated among a preset selection of mutual fund accounts. Life insurance carriers negotiate with various mutual fund companies to have one or more of their funds placed inside the contract, and they’ll get anywhere from 15 to 50 sub-accounts for you to choose from. Your money will grow on a tax-deferred basis until you start taking disbursements. But unlike other annuities, variable contracts are not bound to a specific length of time. Once you buy the contract, it remains in force until you begin withdrawing.

Rather, variable annuities accommodate investors with high risk tolerance and plenty of time to recover from losses. Investors who traditionally invested in mutual funds can use a variable annuity to avoid paying taxes on capital gains each year. Variable contracts are commonly used to fund company retirement plans, such as 401k and 403b retirement plans (a practice that has been the source of controversy in the financial industry for years due to the volatility of these investments).

Getting (and Losing) Money

Getting Paid

Beneficiaries can withdraw funds by using one of six methods:

  • Straight Life. The simplest – and riskiest – form of payout, these payments are based on your insurance carrier’s actuarial calculations about your life expectancy. You’ll be paid every year, even if you outlive the entire value of your contract. But if you die before you get all of the funds in your account, you’ll lose the money.
  • Joint Life. Can extend the length of those payments by adding a co-beneficiary. As long as one of you is alive, the payments keep coming.
  • Life with Period Certain. To cover some of the risk of a straight life payout, you can agree to a set number of payments, over a period of 20 years for example, and if you pass away before the period is up, then a contingent beneficiary would get the remaining years’ payments.
  • Joint Life with Period Certain. Adds a co-beneficiary to the term of your period certain plan.
  • Systematic Withdrawal. A set periodic dollar or percentage payment that ceases upon either death or the depletion of the annuity funds, whichever comes later.
  • Lump-Sum. Liquidating all of the contract’s funds and taking the proceeds in cash.

Fees and Expenses

Along with the potential to make a lot of money, you’ll also deal with several fees and expenses on either an annual, quarterly, or monthly basis.

  • Contingent-Deferred Surrender Charges. Like fixed and indexed annuities, variable annuities usually have a declining sales charge schedule that reaches zero after several years. You may have to pay an 8% penalty to liquidate the contract in the first year, a 7% penalty the next year, and so on until the schedule expires.
  • Contract Maintenance Fee. To (presumably) cover the administrative and record keeping costs of the contract, this fee typically ranges from $25 to $100 per year, although it is often waived for larger contracts, such as those worth at least $100,000.
  • Mortality and Expense Fees. These cover many other expenses incurred by the insurer, such as marketing and commissions. This fee can run anywhere from 1% to 1.5% per year; the industry average is about 1.15%.
  • Cost of Riders. Most variable annuity contracts offer several different types of living and death benefit riders that you can purchase inside the contract. These riders provide some additional guarantees, but each rider usually costs 1% to 2% of the contract value.
Mortality Expense Fees


Fixed, indexed, and variable annuities all get taxed the same way. Any growth in the contract is taxable, and getting your principal back is not. Each payment will reflect the ratio of growth to principal on your contract. If you doubled your money, then half of each disbursement will be taxable. For example, if a distribution is taken from a $300,000 contract for which $150,000 was originally contributed, then the ratio of principal to gain is 50/50. Therefore, half of each distribution is counted as a tax-free return of principal. And don’t forget, as with most other plans, any money you withdraw before you’re 59.5 is subject to a 10% early withdrawal penalty from the IRS.

Sub-Accounts and Other Investment Choices

The sub-accounts housed inside a variable annuity are the real engine that drives the returns realized by the investor. These sub-accounts are actually mutual funds in disguise; they are essentially clones of the underlying funds that exist outside the contract. They resemble their parent funds in most respects but are, by law, treated as separate securities with their own ticker symbols.

For example, Allianz Life offers the Davis New York Venture fund inside its variable annuity products. However, investors who choose to invest in this sub-account are technically investing in a separate security, not the fund offered directly by Davis Funds with the ticker symbol NYVTX that may be purchased on its own. The number and quality of sub-account funds available within the contract will vary from one carrier to another; some variable products offer a much wider array of sub-accounts than others, and not all sub-accounts are equal, just as some funds are superior to others.

Sub-accounts that invest in stocks are classified as large, mid, and small-cap, domestic and global, and sector, just as with funds in the outside world. There are also sub-accounts that invest in all types of bonds, real estate and other securities. All variable contracts also offer a money market sub-account and usually a few fixed alternatives paying a guaranteed rate as well. An investor who purchases a variable contract and then grows leery of the markets can transfer the funds inside the contract into one of the fixed alternatives for a time until the markets recover.

Other Features and Benefits of Variable Annuities

Variable annuities also provide several other benefits in addition to tax-deferral and market participation, such as:

1. Exemptions
Like fixed and indexed annuities, variable contracts are exempt from probate nationwide and also from most creditors in most states. Money inside any annuity contract is passed directly to the beneficiary in the form specified by the contract.

2. Dollar-Cost Averaging
Most modern variable annuity products also provide dollar-cost averaging, which can enhance investment returns and minimize volatility. Many carriers have used DCA programs as a sales tool to entice new investors.

For example, a company may promise to pay a high guaranteed rate of interest in a money market or fixed account while gradually moving the assets from that account into the portfolio of sub-accounts that you select. Therefore, if you invest $100,000 in one of these products, you’d look over the selection of sub-accounts available within the contract and instruct the carrier to allocate a given percentage of your money into each sub-account.

The carrier would then place the money into a fixed fund that pays a rate of interest that is 2% or 3% higher than prevailing rates, and move the money into the sub-account portfolio over perhaps 12 months, transferring $8,500 plus the interest paid to date on that amount into the portfolio each month until you’re fully invested in the portfolio.

3. Portfolio Rebalancing
Many contracts are also able to periodically rebalance the sub-account portfolio to maintain the original asset allocation percentage that was chosen. Because each sub-account will perform differently over time, with some growing at different rates and others perhaps shrinking at times, the initial allocation of funds will eventually become at least somewhat skewed.

Therefore, many contracts offer a rebalancing feature that automatically sells off any units of a given sub-account that are in excess of the allocated portfolio percentage and uses the sale proceeds to purchase additional units of underperforming funds. This also helps investors lock in gains on fast-growing sub-accounts and increase holdings in funds with relatively low prices.

Sub Account Portfolio Balancing

Living and Death Benefit Riders

Variable annuities come with a strong risk of losing your money due to poor sub-account performance, so companies have developed riders that you can purchase to protect your contract value. Death benefit riders usually promise that the contract beneficiary will receive the greater of the current contract value, a sum equal to the growth of the original premium at a certain rate of interest, or the highest value ever achieved by the sub-accounts. Of course, if the current value of the contract exceeds the amounts of these guarantees, then the investor can receive this amount instead.

John invested $100,000 in a variable annuity contract at age 40. He elected this type of rider, and when he is 62 years old, the contract value reaches $511,000 but pulls back sharply the next year. He dies at age 70, when the contract value is worth $405,311. Assuming that the hypothetical rate of growth as described is 5%, then his beneficiary would receive $511,000, because this exceeds both the current contract value and the hypothetical $338,635 that the contract would have grown to at 5% per year until he died.

Living benefit riders guarantee a minimum stream of income upon payout, usually based upon a hypothetical rate of growth. For example, a living benefit may dictate that you’ll receive a payout equal to what you’d get if the contract had grown by a certain percentage each year and then you annuitized it.

Of course, the protection afforded by these forms of insurance protection comes at a cost. Investors can expect to pay an additional 0.75% to 1.5% for each type of rider that is purchased, which can substantially impact the overall return achieved by the portfolio over time.

Do Variable Annuities Fit Your Plan?

Of all the types of annuity contracts, variable annuities tend to appeal to the widest range of investor types. Aggressive investors can place their monies into the small-cap, technology, and foreign stock sub-accounts, while conservative investors can stick to the fixed, money market, or government bond options available within a contract.

Or you can choose to invest aggressively and pay for a living or death benefit rider to protect growth. Of course, moderate investors will find choices that suit them as well. You just need to have enough time before retirement to recover from potentially bad years in the market.

Variable Annuities Plan

Variable Annuities Inside IRAs and Retirement Plans

The tax-deferred status, insurance benefits, and wide range of investment options make variable annuities natural choices for use as funding vehicles for retirement plans, such as 401k and 403b plans and IRAs. Many companies do in fact use variable annuity contracts inside their retirement plans for these reasons.

However, this practice has long been a source of debate within the financial and retirement planning community. And it has become the source of increasing scrutiny from both insurance and securities regulators in recent years.

There are several factors to consider in this debate, each of which you should weigh carefully if you participate in your employer’s retirement plan:

  • Investor Education. Perhaps the biggest problem associated with the use of variable annuities in retirement plans is simply the fact that many people don’t understand exactly what they are purchasing with their retirement savings dollars. In the past, many employee participants believed that they were investing directly in mutual funds and had no idea that they were purchasing them inside an annuity contract that was housed within their retirement plan. The mechanics of the living and death benefit riders can also be confusing in many cases. The regulatory agencies have tightened investor educational requirement in this area for this reason.
  • Costs and Fees. When you factor in all of the costs and charges that are associated with variable annuities, most participants end up paying a total of 2% or 3% of their contract values each year to the annuity carrier. These fees are layered on top of any fees charged by the retirement plan or account itself; many plans charge their own annual administrative or maintenance fees that they pass on to participants like you.
  • Insurance Protection. Proponents of variable annuities have long argued that the various types of insurance protection afforded by the living and death benefit riders easily justify the cost. After all, the two largest assets of many households in America are the home and the company retirement plan. Of course, no one would ever think of leaving their home without homeowners insurance coverage. Shouldn’t your retirement plan be insured as well? This line of reasoning became much sounder after the Enron and Worldcom scandals, as scores of employees saw the company stock and their related plans evaporate almost overnight. The insurance riders in variable annuities can prevent this sort of thing from happening.
  • Commissions. The true deciding factor in many decisions to fund retirement plans with variable contracts has to do with the bottom line – not yours, but that of the broker or adviser recommending the product. Annuities pay considerably higher commissions than most other types of retirement products, including mutual funds. This is especially true for larger amounts of money. Therefore many large IRA rollovers are placed inside these contracts, thus netting the broker a substantial check. Never discount this factor when you’re analyzing the use of annuities inside retirement plans.

There is no true right or wrong answer when it comes to whether variable annuities belong inside retirement plans. If employees clearly understand what they are buying and paying for, and still want the protection offered by the contract, then these products can be very useful. But many employees do not fall into this category and would probably be better served with a selection of standalone funds instead.

Final Word

Variable annuities are complex products with many features that you need to understand clearly so you can use them correctly. These products can accomplish many different investment objectives for many types of investors, from conservative to aggressive. They may be appropriate vehicles for IRAs and other retirement plans in some cases, but not always. For more information on variable annuities, consult your life insurance agent or financial advisor.

What are your thoughts on variable annuities and how do they fit into your retirement plan and investing strategy?


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