Variable Annuity

A variable annuity is an insurance contract that creates a retirement income stream whose value and payout vary with the performance of underlying investments. Investors fund the contract with a lump sum or a series of payments; the insurer invests those funds in sub-accounts (similar to mutual funds) and later pays the investor according to the contract’s terms.

How it works

• Contract parties: investor and insurance company.
• Funding: single premium (lump sum) or periodic payments.
• Phases:
• Accumulation phase — investments grow tax-deferred inside the contract.
• Payout (annuitization) phase — the insurer begins making scheduled payments.
• Payout options: lifetime income for one or two people, a fixed number of payments, or other customized schedules.
• Investment linkage: payouts fluctuate based on sub-account performance; immediate annuities start paying right away, deferred annuities begin at a future date.

Variable vs. Fixed annuities

• Variable annuity: payout and account value depend on market performance of chosen sub-accounts. Potential for higher returns and larger future income, but also exposure to market losses.
• Fixed annuity: insurer guarantees a set return or payment amount, offering stability but typically lower payouts.

Key features

• Tax-deferred growth: investment gains are not taxed until withdrawn or paid out.
• Death benefit: many contracts provide a minimum guaranteed death benefit for beneficiaries.
• Creditor protection: annuity assets are often protected from creditors under state law (varies by state).
• Not FDIC insured: annuities are insurance products, not bank deposits. State guaranty associations may provide limited protection if an insurer fails.

Fees and restrictions

• Common fees: investment management fees, mortality and expense (M&E) charges, administrative fees, and extra costs for optional riders (e.g., guaranteed lifetime withdrawal benefits).
• Surrender charges: withdrawals during the surrender period (often several years) can incur penalties.
• Withdrawal penalties and taxes: withdrawals before age 59½ may trigger a 10% federal penalty in addition to ordinary income tax on gains. Qualified annuities held inside IRAs follow the same tax and required minimum distribution (RMD) rules as those accounts.

Pros and cons

Pros
– Tax-deferred accumulation.
– Potential for higher investment returns than fixed products.
– Flexible payout options, including lifetime income.
– Death benefits and some creditor protection.

Cons
– Investment and market risk — value can decline.
– Often high and layered fees that reduce net returns.
– Surrender periods and liquidity limits make them long-term commitments.
– Complexity — features and fees vary widely by contract.

When a variable annuity may make sense

• You want tax-deferred growth and are comfortable with market risk.
• You need customizable lifetime income features that combine investment growth potential with insurance guarantees (especially with riders).
• You understand and accept the contract’s fees, surrender terms, and liquidity limitations.

Bottom line

Variable annuities offer the potential for market-linked growth and flexible income options but come with higher complexity, fees, and risk than fixed annuities. Carefully review the prospectus to understand investment choices, fees, surrender rules, and guarantee mechanics before buying.