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What Is a Variable Annuity?

A variable annuity is part insurance contract and part investment account. It provides a continuous flow of retirement income determined on the performance of the underlying investment assets you choose – which are usually mutual funds that track stocks, bonds, and much more. It’s also tax-deferred. Unlike fixed annuities which pay a consistent stream of set income, the payout on a variable annuity can change depending on market fluctuations. 

You can purchase a variable annuity contract through either a single, lump-sum payment or a series of payments. You’re also able to choose the types of investments underlying your variable annuity. 

If you’re considering purchasing a variable annuity, it’s important to be well-versed on what is a variable annuity and how does a variable annuity work. We’ve put together this guide as a good place to start. 

How Does a Variable Annuity Work?

A variable annuity works in two phases. The first phase is known as the accumulation phase. The second phase is commonly called the payout phase, or annuitization phase. 

Accumulation Phase

During the accumulation phase, you purchase the variable annuity. You can do this with a single, lump-sum payment, which you could finance by withdrawing from your 401(k) or dipping into your savings. Or you could make a series of smaller payments over a set period of time. 

During the accumulation phase, the money you put into the variable annuity is being invested into underlying assets — typically mutual funds. Most of the time, your money will be invested in a variety of mutual funds that you can choose from. A small percentage of your payments is also going towards fees. 

Disclaimer

You should ask a financial professional about your variable annuity’s investment options. You may also want to request a prospectus of each mutual fund you consider.

Prospectus are free to obtain from financial advisors and contain valuable information about an investment. You can also ask a financial advisor to walk you through the prospectus, help you understand it, help you compare different assets, and help you make a decision. 

Some important factors to consider when analyzing a mutual fund includes the fund’s investment objectives, policies, management fees, and other expenses. You’ll also want to have a thorough understanding of the risks and volatility of a mutual fund before you invest.

Keep in mind that payouts from variable annuities will fluctuate depending on your investment’s performance. Make sure your funds are invested into assets within your risk tolerance

Payout Phase

After you’ve decided how you would like to purchase the variable annuity contract, it’s time to consider how you want to receive the payouts. 

You have two main options for the payout, or annuitization phase. You can choose to either receive your payouts immediately, in which case your variable annuity would be called an immediate annuity. Or you can choose to delay your payments until you reach a set age and allow your investments to accumulate throughout the waiting period. 

You can customize how long you would like your payments to last, be it 30 years or for the entire duration of your life. Keep in mind that size of your payments will vary according to the payout timeframe you’ve selected.

It’s also important to note that once you start receiving your variable annuity payments, you might not be able to withdraw additional funds from your account. 

Variable Annuity Pros and Cons

Like any insurance product or investment asset, variable annuities come with their own unique set of pros and cons. It’s important to be aware of these in order to decide whether a variable annuity makes sense for your financial goals.

Pros of Variable Annuity

With variable annuities, there are certain benefits. Some of the best advantages of variable annuities are the following.

Income Stream

Variable annuities are a great way to guarantee income payments for a set number or years or for the rest of your life. While your income payments might vary depending on how your investments are performing, your income stream is nonetheless guaranteed.

Also, you can include a beneficiary into your variable annuity contract. This ensures your remaining payments are distributed to your spouse, children, or other relatives once you pass away. 

Tax-deferred

With a variable annuity, your investments are able to grow and accumulate tax-free until you decide to withdraw your money. The tax-deferred model helps optimize your investment growth and your future payouts. 

Protection From Creditors

In most states, creditors and debt collectors cannot access your variable annuity.

Unlimited Contributions

401(k)s and IRAs have set annual contribution limits. Many people turn to variable annuities once they’ve maxed out their 401(k) or IRA contributions for the year.

Cons of a Variable Annuity

Variable annuities also come with some downsides as well. Some of the most common disadvantages are as follows.

High Fees

Variable annuities are some of the most expensive financial products on the market. It’s possible for annual fees to range as high as 4%. In comparison, most financial advisors charge only 1% in annual fees.

There are also numerous different fees that can be unclear or complicated to understand. We recommend thoroughly vetting the different fees you will be charged before purchasing a variable annuity. 

Complexity

Variable annuities are also some of the most complex financial products around. They are often difficult to understand and it can be challenging to determine whether they are worthwhile investments on your own. 

We always recommend working with a financial professional like a financial advisor, who can explain these instruments to you. Just make sure they are a fiduciary and are required to put your best interests first. Some non-fiduciaries can receive a hefty commission for selling you a variable annuity that might not always be the best fit. 

Higher Taxes

Variable annuities are tax-deferred investment vehicles, but they also come with less favorable tax treatment than 401(k)s or IRAs. For starters, you cannot claim your contributions as deductions.

Most of the time, your payouts from a variable annuity are taxed as ordinary income and not at the lower tax rate of capital gains. Additionally, if you decide to withdraw your funds early, you’ll be subject to a 10% early withdrawal penalty. 

Fixed Annuity vs Variable Annuity

There are many different types of annuities, but fixed annuities and variable annuities are two of the most common. Both fixed annuities and variable annuities work in a similar fashion. Investors pay either a lump sum of funds or make regular payments during the accumulation phase. Afterwards, insurance companies begin to make payments during the payout phase. So what’s the difference between the two?

Fixed annuities come with a fixed-interest rate. This means the money in your investment account will grow at a predetermined interest rate and your future payouts will be stable. This differs from variable annuities, where investments are typically mutual funds whose values are subject to market conditions. 

Fixed annuities are better suited for conservative investors, because payments won’t ever fluctuate. On the other hand, investors are bound to see smaller growth with a fixed annuity and they run the risk that their payments won’t keep up with inflation levels. 

Variable annuities come with greater risk, but they also offer more potential for higher growth. For these reasons, investors with longer time horizons are typically a better fit for variable annuities – rather than folks looking to retire within a few years.  

How To Choose the Right Annuity

We’ve illustrated the most important things to know about a variable annuity. Unfortunately, there is still a good amount of work to be done before you decide to purchase a variable annuity. For starters, you first need to be sure an annuity is the right solution for your financial goals.

Annuities are one of the most complicated and complex financial instruments. A fiduciary financial advisor is required to put your best interests first to help you make the best decisions. Also, they can help you decide which annuities are a good fit for you. They will create a personalized retirement plan to ensure you’re fulfilling your financial potential. 

Curious about financial advisors but don’t know where to start? Take a look at our guide on how to choose a financial advisor