Variable Annuity: Definition, How It Works, and vs. Fixed Annuity (2024)

What Is a Variable Annuity?

Variable annuities are a type of investment income stream that rises or falls in value periodically based on the market performance of the investments that fund the income. An investor who chooses to create an annuity may choose either a variable annuity or a fixed annuity.

An annuity is a financial product offered by an insurance company and available through financial institutions. The investor pays a lump sum or makes a series of payments into an annuity to fund a guaranteed series of payments that begin at a future date. Annuities are most commonly used to create a regular stream of retirement income.

The fixed annuity is an alternative to the variable annuity. A fixed annuity establishes the amount of the payment in advance.

Understanding Variable Annuities

A variable annuity is created by a contract agreement made by an investor and an insurance company. The investor makes a lump sum payment or a series of payments over time to fund the annuity, which will begin paying out at a future date.

There are many choices available to the investor. The payments can continue for the life of the investor or for the life of the investor or the investor's surviving spouse. It also can be paid out in a set number of payments.

One of the other major decisions is whether to arrange for a variable annuity or a fixed annuity, which sets the amount of the payment in advance.

How Variable Annuities Work

In a variable annuity, the amount of each payment varies based on the performance of an underlying portfolio of sub-accounts. Sub-accounts are structured like mutual funds, although they don't have ticker symbols that investors can easily use to track their accounts.

Two factors contribute to the payment amounts in a variable annuity: the principal, which is the amount of money the investor pays in advance, and the returns that the annuity’s underlying investments deliver on that principal over time.

The most popular type of variable annuity is a deferred annuity. Often used for retirement planning purposes, it is meant to provide a regular (monthly, quarterly, or annual) income stream, starting at some point in the future.

There are immediate annuities, which begin paying income as soon as the account is fully funded.

You can buy an annuity with either a lump sum or a series of payments, and the account’s value will grow over time. In the case of deferred annuities, this is often referred to as the accumulation phase.

The second phase is triggered when the annuity owner asks the insurer to start the flow of income. This is referred to as the payout phase. Some annuities will not allow you to withdraw additional funds from the account once the payout phase has begun.

Variable annuities should be considered long-term investments due to the limitations on withdrawals. Typically, one withdrawal each year is permitted during the accumulation phase.

However, if you take a withdrawal during the contract’ssurrender period, which can be as long as 10 years, you’ll generally have to pay a surrender fee.

As with retirement savings plans like individual retirement accounts (IRAs), the investment growth in the account is not taxed during the accumulation phase. As with IRAs, withdrawals before the age of 59½ will result in a 10% tax penalty as well as taxes due.

Variable Annuities vs. Fixed Annuities

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which offer a guaranteed—but often low—payout during the annuitization phase. (The exception is the fixed income annuity, which has a moderate to high payout that rises as the annuitant ages).

Variable annuities like L share annuities give investors the opportunity to increase their annuity income if their investments thrive. They can invest in their choice of a menu of mutual funds offered by the insurer.

The upside is the possibility of higher returns during the accumulation phase and a larger income during the payout phase. The downside is that the buyer is exposed to market risk, which could mean losses.

With a fixed annuity, the insurance company assumes the risk of delivering whatever return it has promised.

Variable Annuity Advantages and Disadvantages

In deciding whether to put money into a variable annuity vs. some other type of investment, it’s worth weighing these pros and cons.

Below are some details for each side.

Advantages

1. Variable annuities grow tax-deferred, so you don’t have to pay taxes on any investment gains until you begin receiving income or make a withdrawal. This is also true of retirement accounts such as traditional IRAs and 401(k)s.
2. You can tailor the income stream to suit your needs.
3. If you die before the payout phase, your beneficiaries may receive a guaranteed death benefit.
4. The funds in an annuity are off-limits to creditors and other debt collectors. This is also generally true of retirement plans.

Disadvantages

1. Variable annuities are riskier than fixed annuities because the underlying investments may lose value.
2. If you need to withdraw money from the account because of a financial emergency, you may face surrender fees. Any withdrawals you make before age 59½ may be subject to a 10% tax penalty.
3. The fees on variable annuities can be quite hefty.

The Bottom Line

Before buying a variable annuity, investors should carefully read the prospectus to understand the expenses, risks, and formulas for calculating investment gains or losses. Annuities are complicated products, so that can be easier said than done.

Bear in mind that between the numerous fees—such as investment management fees,mortality fees, and administrative fees—and charges for any additional riders, a variable annuity’sexpenses can quickly add up.

That can adversely affect your returns over the long term, compared with other types of retirement investments.