Variable Annuitization: What It Is and How It Works

Variable annuitization is an option for converting an annuity’s accumulated value into a stream of periodic income payments that fluctuate with the performance of the annuity’s underlying investments. It’s chosen during the annuitization phase, when the contract holder exchanges the contract’s value for guaranteed income for life or for a set period.

How it works

• Accumulation phase: The investor contributes premiums to the annuity. Earnings grow tax-deferred in sub-accounts that resemble mutual funds.
• Annuitization decision: When the investor wants regular income, they can either take withdrawals or annuitize the contract. If they annuitize, they choose between fixed or variable payment options.
• Variable payments: Payments are recalculated periodically based on the performance and value of the selected sub-accounts. If investments do well, payments can increase; if they decline, payments can decrease.

Tax treatment

• Annuities bought with after-tax dollars: During annuitization, part of each payment is typically treated as a non-taxable return of basis; the remainder is taxed as ordinary income. Withdrawals before all earnings are distributed tend to be taxed as income first.
• Annuities bought with pre-tax dollars (e.g., in an IRA): Payments are generally fully taxable as ordinary income.

Fixed vs. variable annuitization — quick comparison

• Certainty: Fixed annuitization provides a consistent payment amount. Variable annuitization provides payments that can rise or fall with investment performance.
• Growth potential: Variable offers greater upside if markets perform well.
• Risk: Variable exposes the holder to market volatility; payments can fall in downturns.
• Inflation: Variable annuitization can offer some real growth potential; fixed payments lose purchasing power unless indexed.
• Fees: Variable annuities typically carry higher fees (investment management, mortality and expense, rider costs) than fixed annuities.

Key considerations before choosing variable annuitization

• Complexity and costs: Variable annuities are complex and may include multiple fees and riders that reduce returns.
• Liquidity and surrender charges: Many annuities impose penalties for early withdrawals or have long surrender periods.
• Investment risk: Value and income depend on sub-account performance—losses can reduce future payments.
• Commissions and conflicts: Sellers often earn commissions; understand any incentives or compensation arrangements.
• Guarantees and riders: Optional guaranteed-lifetime-income or death-benefit riders can reduce investment risk but increase costs.
• Suitability: Consider time horizon, risk tolerance, tax situation, retirement income needs, and alternative investments.

Pros and cons

Pros
– Tax-deferred growth during accumulation.
– Potential for higher retirement income if investments perform well.
– Access to lifetime income options and optional guarantees.

Cons
– Payments can fall with poor investment performance.
– High fees and complexity can erode returns.
– Limited liquidity and possible surrender charges.
– Sales commissions and product conflicts of interest.

How to decide

1. Clarify retirement income needs and risk tolerance.
2. Compare fixed vs variable annuity projections, fees, and riders.
3. Review sub-account options and historical performance (keeping fees in mind).
4. Assess tax implications based on whether the annuity is funded with pre- or after-tax dollars.
5. Consult a qualified, fiduciary financial or tax advisor to evaluate suitability and alternatives.

Takeaway

Variable annuitization can provide tax-deferred growth and the potential for increasing retirement income, but it exposes holders to investment risk and typically carries higher fees and complexity than fixed options. Evaluate guarantees, costs, liquidity, and your personal retirement goals before choosing variable annuitization. Regulatory authorities caution that variable annuities require careful consideration because of their complexity and costs.