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


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Give me some money, preferably in a lump sum. I promise to pay it back — with interest — when you’re older. Those payments could continue for the rest of your life.

Sound too good to be true? Think again. This is the basic principle of a fixed annuity, a type of insurance product that offers guaranteed retirement income for the buyer. Fixed annuities have been around for millennia, dating at least back to ancient Rome.

By that standard, variable annuities are mere babies. They’ve only been around since the 1980s, when yield-hungry Wall Streeters decided to gussy up the staid annuity with a little dash of equities exposure — and risk. 

If the market cooperates, a variable annuity could earn you a lot more than a fixed annuity with a guaranteed, generally low rate of return. But if the market crashes, you could earn nothing at all. So before you put your life savings into one, understand how it works, how it differs from other types of annuities, and the potential benefits and risks it could bring.


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What Is a Variable Annuity?

A variable annuity is a contract between you and an issuer, most often an insurance company. As with other annuities, you fund it with a lump-sum payment or series of payments over a number of years.

Over time, the money you contribute to your variable annuity has the potential to grow on a tax-deferred basis. However, unlike other types of annuities, variable annuities don’t guarantee a particular rate of return. They might not even guarantee to protect your principal — your contributions. In a worst-case scenario, you can lose all the money you put into a variable annuity, although this is unlikely.

Like other types of annuities, variable annuities offer the promise of regular payments at some point in the future. These payments begin after a one-time event known as annuitization, the point at which you can no longer contribute to the contract or tap its value directly. 

This income stream lasts for a predetermined number of years. Depending on the terms of the contract, the insurance company may guarantee these income payments for life. If you die before the payments are set to end, your named beneficiaries may be entitled to them. If you die before your annuity payments begin, your named beneficiary stands to receive a death benefit that’s typically at least equal to your total contributions to date.


How Variable Annuities Work

Your annuity’s payments depend on the underlying value of your annuity contract. In turn, that value depends on how much you contribute to the contract, how much time the contract has had to grow, and how the assets held by the contract have performed.

Variable Annuity Investments

When you invest in a variable annuity, you can choose to allocate your funds 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 typically get a few dozen subaccounts for you to choose from. 

Taxes on Variable Annuities

Once invested, your money grows on a tax-deferred basis. This tax-deferred growth occurs even if the annuity isn’t held inside an IRA or employer-sponsored qualified plan, such as a 401(k) or 403(b) retirement plan. If you habitually invest in mutual funds, a variable annuity is a useful way to avoid paying taxes on capital gains generated by those funds each year.

You will pay taxes on your annuity’s growth eventually, however. If you make a withdrawal before reaching age 59 ½, you may incur a 10% tax penalty on the withdrawal amount. You’ll also pay income tax on the earnings, regardless of when you withdraw. The IRS taxes earnings at the higher ordinary income rate, not the lower capital gains tax rate.

The good news is that the principal portion of each variable annuity distribution is not taxable. So, if you contribute $100,000 total to a variable annuity and the value of the contract grows to $500,000 at annuitization, you’ll only pay taxes on 80% of each distribution.

Additionally, most insurers allow you to withdraw 10% or 20% of your annuity value each year before age 59 ½ without incurring the 10% tax penalty. 

Variable Annuity Payment Options

Insurance companies offer multiple payment options for variable annuity holders. When you set up your contract, you’ll need to choose at least one.

  • Straight Life. This is the simplest and riskiest option. Your payment amount is 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 the funds in your account, your heirs will lose any unpaid money.
  • Joint Life. You can extend the length of your payments — and the total amount paid out by the contract — by choosing this option, which adds a co-beneficiary to the contract. Typically, this is a spouse or domestic partner. As long as one of you is alive, the payments keep coming.
  • Life with Period Certain. To reduce the risk of a straight life payout, you can agree to a set number of payments over a set period of time, typically at least five years but often longer. If you die before the period ends, a contingent beneficiary — such as a child or other close relative — gets the remaining years’ payments. 
  • Joint Life with Period Certain. This option adds a co-beneficiary to the term of your period-certain plan. It makes sense if you’re married or living with a domestic partner and want them to receive payments before any contingent beneficiaries.
  • Systematic Withdrawal. This option sets periodic payments in a specific dollar amount or percentage. Payments end when you die or when the annuity is depleted, whichever comes later.
  • Lump-Sum. Finally, you can choose to liquidate the contract all at once and take the proceeds in cash. You’re then free to reinvest them as you see fit. 

Variable Annuities vs. Fixed Annuities

Unlike fixed and equity-indexed annuities, variable annuities do not guarantee your principal investment, interest, or other gains. They also invest in riskier assets — namely, stock mutual funds. Fixed annuities invest in government bonds and other relatively low-risk securities.

Variable Annuity Time Horizon

Variable annuities can remain in force indefinitely. Once you buy the contract, it exists until you begin making withdrawals, whether that’s five or 50 years down the road.

This long time horizon somewhat offsets the higher risk of variable annuities by making it more likely they’ll recover their losses from market downturns. 

Variable Annuity Returns

Unlike fixed annuities, variable annuities don’t offer guaranteed returns. However, their upside is much higher. If the value of the assets in your annuity’s mutual fund subaccounts increases by 20% this year, the total account value of your annuity increases by a corresponding amount, less fees and trailing commissions. 

Of course, that kind of performance is unlikely to be sustained over many years. And those fees and commissions can be substantial.

Variable Annuity Fees and Commissions

Compared with individual stocks and exchange traded funds (ETFs), annuities are expensive, and variable annuities are the most expensive type of annuity. Expect fees and commissions to significantly reduce your contract’s net earnings.

These are some expenses you may encounter when you buy a variable annuity:

  • Commissions. Annuity commissions are set up as trailing commissions spread out over a number of years. Variable annuity commissions are particularly steep — often 5% to 10% of the contract value.
  • Administrative Fee. Think of this as the contract’s annual management fee. It’s usually low, on the order of 0.3% of the contract value. 
  • Surrender Charges. Early principal withdrawals can trigger surrender charges if they occur within the surrender period, which can stretch as long as 10 years from the contract’s start date. Surrender charges typically start between 5% and 10% of the withdrawal amount and decline each year until disappearing entirely. 
  • Investment Expenses. These are fees charged by the mutual funds held in your subaccounts. They vary depending on the fund type and how it’s managed, ranging from under 0.3% annually for passively managed funds to over 1% for actively managed funds. To reduce your investment expenses, choose passively managed investment options.
  • Mortality Expenses. This is a surcharge that helps reduce the insurer’s financial risk. It averages 1% of the contract value. 

Pros & Cons of Variable Annuities

The idea of a variable annuity sounds enticing. You put in some seed money, reap stock market-level returns while you wait, and get predictable payments in your later years.

But variable annuities have significant drawbacks as well.

Variable Annuity Pros

Variable annuities have higher growth potential than other types of annuities while still providing the promise — if not guarantee — of lifetime income with the potential to outlive the original contract owner.

  1. High Growth Potential. Variable annuities invest in funds that hold stocks and other assets with high growth potential. Compared with fixed annuities, which offer a predictable but flat rate of return, variable annuities have more upside.
  2. May Provide Lifetime Income. Like all annuities, variable annuities offer the potential but not the guarantee of lifetime income. If you’re looking for supplemental income in retirement, that’s an attractive prospect.
  3. Income May Outlive the Buyer. If you choose a payout plan designed to outlive you, your variable annuity could provide income for your surviving spouse or other heirs after you die. 
  4. Long-Term Tax Deferral Outside a Retirement Plan. Like all annuities, variable annuities aren’t taxed until withdrawals begin. And because annuities don’t have government-imposed contribution limits, those tax savings can really add up.

Variable Annuity Cons

Variable annuities are the riskiest type of annuity. They’re also the costliest, and their tax benefits may not be all they’re cracked up to be.

  1. High Fees and Commissions. All annuities are expensive, and variable annuities more so than others. If you don’t want to wrestle with an alphabet soup of fees and trailing commissions that can linger for years, consider investing directly in mutual funds — or, better yet, more tax-efficient ETFs.
  2. Distributions Taxed As Ordinary Income. The IRS taxes annuity distributions as ordinary income, not capital gains. That likely means you’ll pay more in tax on your annuity withdrawals than you would by selling investments held in a taxable brokerage account.
  3. Potential for Significant Loss. A variable annuity is the riskiest type of annuity around. Its value is closely linked to that of the underlying subaccounts, which hold a mix of stocks and other market-traded investments. When the stock market falls, the value of your variable annuity likely falls as well. 
  4. Low Liquidity. Your variable annuity’s value is not as easy to tap as your bank or brokerage account’s. If you make a withdrawal before age 59 ½, expect to pay a stiff penalty.
  5. Not Government-Guaranteed. Unlike bank account balances, annuity balances aren’t guaranteed by a federal government entity like the FDIC. If the insurer that issued the contract fails, you could lose your entire investment.

Variable Annuity FAQs

Variable annuities are complicated. If you still have questions about how they work, how much they cost, and whether they make sense for you and your family, we have answers.

How Much Do Variable Annuities Cost?

One way to think about a variable annuity’s cost is to think about how much you put into it. 

This is your annuity’s principal. Because it’s tied up in the contract, you can’t use it for other things unless you make a withdrawal, which could carry a stiff cost early in the contract.

On the bright side, variable annuities are designed to be long-term investments that grow over time. If all goes well with your investment choices, your principal will grow, creating a nice nest egg for your later years.

On the not-so-bright side, that nest egg’s value will erode due to other fees and expenses. These include but aren’t limited to:

  • Trailing commissions charged for years after the contract goes into effect
  • Administrative fees charged every year
  • Annual fund expenses charged by the assets held in your investment portfolio
  • Surrender charges levied on premature withdrawals
  • Mortality expenses charged by the insurer to manage the contract’s inherent risk

Always review your contract for other potential fees, such as third-party transfer fees and underwriting fees. If you’re not sure what a particular fee does, ask the insurer what it’s for and how it affects the performance of the investment. 

How Are Variable Annuities Taxed?

Your variable annuity balance isn’t subject to income tax until you begin making withdrawals. That goes for any capital gains realized by the underlying investment options. That could make it more tax-efficient to invest in mutual funds through an annuity rather than a taxable brokerage account. 

Any gains earned by your annuity are subject to ordinary income tax when withdrawn. If you make a withdrawal before age 59 ½, you may face an additional 10% income tax penalty. 

Can You Cash Out a Variable Annuity Early?

Yes. But it could cost you.

If you make any withdrawals before age 59 ½, you could face a 10% tax penalty in addition to ordinary income tax on any gains. 

Your insurer might allow you to make relatively small withdrawals — up to 10% to 20% of the contract value — before age 59 ½. But you’d still face a penalty for most of the contract value if you cashed out the entire thing. 

If you cash out after age 59 ½ but before annuitization, you’ll still have to pay income taxes on your gains. 

If you cash out during the surrender period, you may face a surrender charge as well. Early on, this could approach 10% of the withdrawal amount in addition to the tax penalty and ordinary income taxes. 

What Happens to a Variable Annuity if the Stock Market Crashes?

The value of a variable annuity contract depends on the value of the underlying investments — the subaccounts you allocated your contributions to. If those subaccounts are invested in stocks and the stock market goes down, they lose value. 

How much value can your variable annuity lose if the stock market crashes? It depends on the specific stocks your subaccounts hold and what (if any) downside protection your contract offers. 

Most annuities at least offer principal protection, meaning the contract value can’t decline below your total contributions. But not all variable annuities do, so be sure to check your contract’s fine print before investing.

What Happens to My Variable Annuity if I Die?

If you have a joint annuity set up with a spouse or domestic partner, your partner should continue to receive payments after your death as long as the contract has value. 

Likewise, you can expect your heirs to continue receiving payments on a period-certain contract if you die during the guaranteed payment period.

Your variable annuity should also come with a death benefit. This provides a guaranteed payment to your named beneficiaries that’s at least equal to your total contributions.


Final Word 

Investors see the blue-chip insurance companies that back annuity contracts as unlikely to default on their obligations. As a result, they treat annuity contracts as relatively safe investments. 

Still, there’s a big difference between a fixed annuity — where principal, growth, and payments are all guaranteed — and a variable annuity, which can lose value and might not even protect investors’ contributions. 

Investing in a variable annuity is your best bet if you want your annuity’s performance to match or even exceed historical stock market returns. However, what goes up can also go down. The value of your variable annuity can decline precipitously, threatening the lifetime income you’ve been counting on. 

A variable annuity could be the right choice for you and your family. But be sure to consult a seasoned fiduciary financial professional — someone who’s not earning a commission selling you the annuity — before proceeding.

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Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.

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