Out of all the categories of annuities, a variable annuity is often the most misunderstood. That is because variable annuities have many moving parts, including a range of investments to which premiums may be deposited. Before getting ahead of ourselves, it is necessary to understand how a variable annuity differs from a fixed or indexed annuity. In the simplest terms, a variable annuity is a tax-deferred vehicle used for retirement savings that provides options for internal investments and the potential for guaranteed income in the future based on investment performance.
How Variable Annuities Work
Like fixed and indexed annuities, variable annuity contracts are established with either a single premium deposit or systematic deposits over several months or years. Unlike other annuity categories, variable annuities are meant to be long-term retirement savings vehicles, and as such, immediate income is not generally an option. Instead, variable annuities allow you to invest the premium over the course of several years into subaccounts which may provide a higher return than fixed or indexed annuity vehicles.
Subaccounts within a variable annuity are professionally managed by mutual or index fund professionals, and they operate similarly. You can select the type of subaccount that meets your risk tolerance and time horizon, or desire for growth or stability. Each variable annuity offers different subaccounts to choose from, and they may allow changes to subaccounts over time as risk tolerance shifts. The subaccounts are meant to give investors a higher return than what may be available with interest rates for fixed annuities or earnings caps with indexed annuities. However, subaccounts, like all other investments, come with market risk.
Variable annuities are a common retirement savings vehicle for individuals who feel comfortable participating in the market. Insurance companies offering variable annuities also provide some downside protection, like indexed and fixed annuities, however. This insurance comes in three broad categories: annuitization, living benefits, and death benefits. Here is a brief overview of each.
As with other annuity contracts, variable annuities provide for annuitization which is the process of converting your account balance to steady income over your lifetime or a set period. When annuitization takes place in a variable annuity, the balance is essentially turned over to the insurance company, and it dictates payments based on age and the annuity account value. Investing in subaccounts before the annuitization period can help increase income payments if the market performance is strong. Alternatively, weak market performance may mean there is little or no increase in income payments when annuitization begins.
Another insurance component of a variable annuity is a living benefit, referred to as a rider, attached to the initial contract. With a variable annuity living benefit, the investment is insured against market downturns, up to a certain amount. Living benefits come in many forms depending on the issuing company.
Insurance companies offering variable annuities also provide death benefits to beneficiaries. Most enhanced death benefit options with variable annuities ensure the initial investment amount, less any withdrawals is paid to account beneficiaries upon the annuitant’s death. The initial premium payment is then insured against market declines, so long as the death benefit rider is selected at the time the contract is put in place.
The Benefits of Variable Annuities
There are inherent benefits to variable annuities which attract investors, the most apparent being the option to invest in the market with the promise of downside protection should subaccounts not perform well over time. Additionally, variable annuities allow for guaranteed lifetime or period-certain income based on subaccount performance, living benefit riders, or a combination of the two. This offers more flexibility than indexed and fixed annuities in managing income before and during retirement for many investors.
Variable annuities also offer tax deferral on premiums and investment gains when a contract is established as a non-qualified (non-retirement) account. Qualified accounts, including IRAs, ROTH IRAs, rollover IRAs and beneficiary IRAs may also be transitioned to a variable annuity, although they do not receive any additional tax deferral or benefits when doing so. Variable annuities also have no contribution limits like individual retirement accounts do, with the exception of restrictions in place at each insurance company.
Finally, variable annuities offer some assistance in planning for joint retirement income through spousal riders and annuitization options. Some features give protection to spouses of the annuitant so that income can continue even after he or she has passed away.
Drawbacks to Variable Annuities
While variable annuities have specific benefits not found with indexed or fixed annuities, there are drawbacks to consider. First, variable annuities get a negative reputation because of the often complex layers of fees charged to investors. Subaccounts have internal charges known as expense ratios which eat away at returns over time. Similarly, living and death benefit riders come with costs that can be upward of 1% of the account value. Standard annuitization options do not typically have fees, but the combination of other expenses can be steep for investors, ultimately reducing the benefit of a variable annuity.
Variable annuities also have investment risk because of the subaccount design. Over time, poor-performing subaccounts have the potential to decrease the total value of the account. Without a rider in place, these declines could reduce guaranteed monthly income in the future.
Like other annuities, variable annuities also have surrender schedules that can range from a few to several years. Should money be moved from the annuity before the surrender schedule is complete, the insurance company withholds a percentage of the value as a penalty. This means variable annuities are not highly liquid, which can be problematic for investors with little access to other savings or investments.
Variable annuities are complex given their features, various benefit riders, and subaccount selections. They can provide growth of guaranteed income in the future for the right investor, but only when the details of the contract, including fees, surrender schedules, and investment risks are understood from the start.