Variable Annuity

What Is a Variable Annuity?

A variable annuity is a contract between an investor and an insurance company. The investor pays premiums, either in a lump sum or over time, and the money is placed into a set of investment options. The account value rises and falls with those investments, so the eventual payments are not fixed in advance. Variable annuities are generally used for retirement savings and are regulated as both insurance products and securities.

How It Works

During the accumulation phase, premiums are allocated to sub-accounts, which are similar to mutual funds and hold stocks, bonds, or other assets. Growth in these accounts is generally tax-deferred, meaning the investor does not owe income tax on gains until money is withdrawn. Withdrawals made before age 59½ may trigger an additional tax penalty on earnings. Many contracts also impose a surrender charge on withdrawals or cancellations made during the first several years.

When the investor chooses to receive income, the contract can be converted into periodic payments, either for a set period or for life. Many contracts also offer optional riders, such as a guaranteed minimum death benefit or a guaranteed minimum withdrawal benefit. These add protection but carry an additional cost.

Fees and Costs

Variable annuities are known for layered fees. These commonly include a mortality and expense risk charge, administrative fees, the expense ratio of each underlying sub-account, and charges for any optional riders. Taken together, these costs can be substantial over time and can reduce the growth available to the investor.

Advantages and Disadvantages

Potential advantages include tax-deferred growth, the possibility of lifetime income, and optional guarantees. Potential disadvantages include high costs, surrender charges, complexity, and market risk, since the account value can fall unless a rider provides a guarantee. Because the contracts can be difficult to compare, investors often review the prospectus and contract terms carefully before buying.