A variable annuity is a contract with an insurance company designed to help you save for retirement or other long-term financial goals.
Under a variable annuity contract, an insurance company agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.
The Core Mechanism Explained
Think of a variable annuity as a two-part financial product: an insurance contract and an investment vehicle.
- Purchase: You buy the contract from an insurance company by making contributions. These contributions can be a one-time lump sum or regular payments over time.
- Investment: Unlike fixed annuities which offer a guaranteed interest rate, variable annuities allow you to invest your purchase payments in various investment options, typically called sub-accounts. These sub-accounts are similar to mutual funds, investing in stocks, bonds, money market instruments, or a mix of these.
- Growth Potential: The value of your annuity fluctuates based on the performance of the sub-accounts you choose. This offers the potential for growth but also carries investment risk – if the sub-accounts perform poorly, the value of your contract can decrease.
- Periodic Payments: At a future date you select (or immediately in some cases), you can begin receiving income payments from the insurance company. The amount of these periodic payments will vary depending on the performance of your chosen sub-accounts.
Key Phases of a Variable Annuity
Variable annuities typically have two main phases:
- Accumulation Phase: This is the period when you are making purchase payments into the annuity. Your money is invested in the sub-accounts, and the value of your contract grows or shrinks based on investment performance. Earnings during this phase grow tax-deferred.
- Annuitization Phase: This is when you convert your accumulated value into a stream of periodic income payments. You can choose different payout options, such as payments for a set number of years or payments for the rest of your life. The payment amount is variable, linked to the performance of the underlying investments.
| Feature | Accumulation Phase | Annuitization Phase |
|---|---|---|
| Purpose | Growing savings | Receiving income payments |
| Contributions | You make purchase payments | You no longer make payments (generally) |
| Value Fluctuation | Based on sub-account performance (variable balance) | Payment amount varies based on sub-account performance |
| Tax Treatment | Tax-deferred growth | Payments are taxed (portion may be tax-free return of principal) |
Understanding Sub-Accounts
Sub-accounts are the investment engine of a variable annuity. When you purchase a variable annuity, you allocate your money among a selection of sub-accounts offered by the insurance company. These can range from aggressive stock funds to conservative bond funds or even guaranteed options. Your allocation choice directly impacts the potential for growth and the level of risk you take.
Other Features and Considerations
- Death Benefit: Most variable annuities include a death benefit, guaranteeing that if you die before annuitizing, your beneficiaries will receive a certain amount, often the amount of your original purchase payments (minus withdrawals) or the contract value, whichever is greater.
- Riders: Insurance companies offer various optional riders that you can add for an extra fee. These might provide guaranteed minimum income benefits, enhanced death benefits, or other features.
- Fees and Expenses: Variable annuities can have several layers of fees, including:
- Mortality and Expense (M&E) risk charges (for the insurance guarantees like the death benefit and annuitization options)
- Administrative fees
- Fund expenses (within the sub-accounts)
- Rider costs
- Surrender charges (if you withdraw money within a certain period)
Practical Insights:
- Variable annuities offer growth potential linked to market performance, unlike fixed annuities.
- The periodic payments you receive during annuitization can fluctuate, providing less predictability than fixed annuity payments but potential for growth.
- Due to their complexity and fee structure, variable annuities are typically considered long-term investments.
Variable annuities provide a unique way to invest for retirement with potential growth tied to market performance and the option to receive periodic income payments from an insurance company.
