In this series of articles, we describe the different types of annuities available for retirement savings. In Part 1 of the series we explained there are three main categories: Fixed Annuities, Variable Annuities and Indexed Annuities, and described the first type, Fixed Annuities. In this article, Part 2 of this series, we answer the question, What is a Variable Annuity? In Part 3, we cover Indexed Annuities.
To quickly review the basics, in Part 1 we noted that all three types of annuities allow you to invest money, tax-deferred, to generate income in retirement, that they all provide some type of guaranteed payments made at regular intervals for a specific number of years, or for the rest of your life, and that when you receive payments from an annuity, starting any time after age 59 ½, you pay taxes only on the portion that comes from investment income. Now, let’s turn to the topic of this article,
What is a variable annuity?
A variable annuity allows you to specify how your annuity money is invested, either in the stock market, the bond market, or a combination of the two, typically using mutual funds. You typically choose from a wide array of funds that cover all types of markets, including U.S. equity and bond funds, global funds, and those that specialize in certain regions or types of investments. The payments you ultimately receive from a variable annuity are determined by the performance of the investments you select.
As with a fixed annuity, you pay no taxes on the investment returns in a variable annuity until you start to receive payments from that annuity (any time after you turn 59 ½). You owe taxes only on the investment returns, not on the original principal invested, and you are not required to start withdrawals at any particular age, so you can invest tax-deferred for many years. If you are in a lower tax bracket after you retire, as many people are, you keep more of your investment returns compared to holding the same investments in a regular brokerage account, where you pay taxes annually.
Variable annuities can include something called a “guaranteed lifetime withdrawal benefit” – yes, it’s a mouthful, often abbreviated as “GLWB”. It allows you to combine the benefits of investing in the markets with a level of guaranteed future income. A variable annuity with a GLWB addresses the concern many people have about fixed annuities, which guarantee regular payments but do not allow the annuity holder to benefit from returns offered by the stock and bond markets.
With a variable annuity, while you participate in market returns through your chosen funds, the insurance company that provides the annuity guarantee you won’t lose your principal. The insurer also takes on the risks that if the market drops and your chosen investments decline in value: (1) the returns might not be sufficient to cover the death benefit due to your heirs if you die before the annuity period ends, (2) the returns investments might not be sufficient to cover your GLWB (guaranteed minimum benefit for life). For these reasons, variable annuities involve higher fees than fixed annuities.
During the period between when you purchased the annuity but before the date you chose to start receiving payments (called the “accumulation phase”) it can be difficult and costly to access any of the money you’ve invested. This is largely because the insurance company providing the annuity pays a commission to the broker who sold the annuity, and invests some of your money in a way that ensures they will be able to meet your minimum benefits in the future. Taking the money out sooner than planned could generate losses for the insurer. You would typically have to pay a “surrender charge” to withdraw your money early, and you would most likely have to pay taxes and perhaps penalties on returns your annuity investments had produced up to that point.
Variable annuities can combine many of the features of a fixed annuity along with the benefits of investing in the markets. They can also be a disciplined way of investing for the long-term (the surrender charges and penalties associated with taking money out of an annuity too soon tends to stop people from dipping into that pool of money). Be sure the investment choices offered by the annuity provider satisfy your needs, and that you understand the fees associated with your variable annuity.