What Is Variable Annuities?
Variable annuities are complex financial products offered by insurance companies that combine features of investment products with insurance benefits, primarily designed for retirement planning. As a type of insurance contract, they allow for investments in a selection of underlying subaccounts, which typically invest in stocks, bonds, or money market instruments, similar to mutual funds. The value of a variable annuity fluctuates based on the performance of these chosen subaccounts, offering the potential for capital appreciation and tax-deferred growth during the accumulation phase. They belong to the broader category of investment products and include unique insurance features, such as a guaranteed death benefit or income riders, distinguishing them from direct investments in mutual funds19, 20.
History and Origin
The concept of annuities, providing a stream of payments for life or a specified period, has roots tracing back to ancient Rome. In the United States, private annuity markets began to develop significantly in the 1930s, driven by a desire for financial stability during challenging economic times18. The advent of variable annuities represented a pivotal evolution in the annuity landscape. These products, which combine the investment features of mutual funds with the tax deferral characteristic of insurance products, saw rapid expansion in the latter half of the 20th century. A key moment in their history occurred in 1959 when the U.S. Supreme Court ruled that variable annuities are securities and thus subject to registration and regulation by the Securities and Exchange Commission (SEC)17. This decision cemented their dual nature as both insurance contracts and investment vehicles, paving the way for the regulatory oversight that exists today.
Key Takeaways
- Variable annuities are insurance contracts that allow for tax-deferred investment growth based on underlying subaccounts.
- Unlike traditional investments, they offer unique insurance benefits such as death benefits and optional living benefit riders.
- Their value fluctuates with market performance, meaning investors bear market risk associated with the underlying investments.
- Variable annuities are subject to various fees and surrender charges, which can significantly impact returns.
- They are generally considered long-term investments, suitable for retirement and other extended financial goals.
Interpreting the Variable Annuities
Interpreting a variable annuity involves understanding its two main phases: the accumulation phase and the payout or distribution phase (also known as annuitization). During the accumulation phase, the contract holder makes purchase payments, and the invested capital grows or declines based on the performance of the chosen subaccounts. The value during this phase is represented by the contract's accumulated value. In the payout phase, the accumulated value can be converted into a stream of regular income payments, which can be for a set period or for life.
When evaluating a variable annuity, it is crucial to consider the underlying investment performance of its subaccounts, the various fees and expenses deducted, and the value of any guaranteed benefits or riders. The balance between potential investment growth and the cost of insurance features shapes the product's overall value proposition.
Hypothetical Example
Consider an investor, Sarah, aged 50, who purchases a variable annuity with a $100,000 single premium. She allocates her investment across several of the annuity's subaccounts, aiming for a diversified asset allocation.
Year 1:
Sarah's chosen subaccounts perform well, and her initial $100,000 grows by 8%, reaching $108,000. During this year, the insurance company deducts various fees, including mortality and expense risk charges, administrative fees, and an optional living benefit rider fee, totaling 3% of her average account value, or approximately $3,120 ($104,000 average * 0.03).
- Initial Investment: $100,000
- Investment Growth: $8,000 (8% of $100,000)
- Fees: $3,120
- Account Value End of Year 1: $100,000 + $8,000 - $3,120 = $104,880
Year 5:
After five years, assuming an average annual net growth of 4% after fees, Sarah's variable annuity account could have grown to approximately $121,665. At this point, she decides to take a partial withdrawal of $15,000. If her contract includes a 7% surrender charges that applies for seven years and she has already withdrawn her annual penalty-free amount, she might incur a charge on a portion of the withdrawal. If $5,000 was her penalty-free amount, she'd pay a surrender charge on the remaining $10,000 (7% of $10,000 = $700). Her withdrawal would be $14,300. The remaining balance continues to grow on a tax-deferred basis.
Practical Applications
Variable annuities are primarily utilized in personal financial and retirement planning for their potential for long-term, tax-deferred growth and their unique insurance features. They are often considered by individuals who have maximized contributions to other tax-advantaged retirement accounts, such as 401(k)s or IRAs, and are looking for additional avenues for retirement savings with investment flexibility16.
Beyond wealth accumulation, variable annuities serve as a mechanism for income generation in retirement through annuitization15. This feature allows the contract holder to convert their accumulated value into a guaranteed stream of income payments for a specified period or for life, offering protection against the risk of outliving one's assets. Regulatory bodies, such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), provide extensive guidance and oversight for variable annuities due to their complexity, emphasizing the importance of understanding their features, benefits, and risks before investing14.
Limitations and Criticisms
Despite their potential benefits, variable annuities face several limitations and criticisms. A primary concern is their often-high fee structure. These products typically involve multiple layers of costs, including mortality and expense risk charges, administrative fees, underlying fund expenses (for the subaccounts), and additional charges for optional riders (e.g., guaranteed living or death benefits)12, 13. These cumulative fees can significantly erode investment returns over time, potentially outweighing the benefits of tax deferral or insurance guarantees.
Another notable criticism revolves around illiquidity and surrender charges. Variable annuities are designed as long-term investments, and withdrawing funds before a specified period, often 5 to 10 years, can trigger substantial surrender charges, penalizing early access to capital11. Furthermore, suitability is a significant point of contention. Due to their complexity and cost, regulators like FINRA emphasize that variable annuities may not be suitable for all investors, particularly those with shorter investment horizons or those who prioritize liquidity9, 10. Instances of inappropriate sales practices and "switching" or "churning" of variable annuities, where advisors recommend replacing an existing annuity not for the investor's benefit but to generate commissions, have led to increased regulatory scrutiny and investor complaints7, 8.
Variable Annuities vs. Fixed Annuities
Variable annuities and fixed annuities are both insurance contracts designed for retirement savings, but they differ fundamentally in how their cash value grows and the investment risk borne by the investor.
| Feature | Variable Annuity | Fixed Annuity |
|---|---|---|
| Investment Growth | Tied to the performance of underlying subaccounts | Guaranteed interest rate set by the insurer |
| Investment Risk | Borne by the investor (potential for loss) | Borne by the insurance company (guaranteed principal) |
| Growth Potential | Higher, as it participates in market gains | Lower, limited by the guaranteed rate |
| Fees & Expenses | Generally higher, due to investment management and insurance features | Generally lower, fewer moving parts |
| Complexity | More complex, requires active investment selection | Simpler, more straightforward |
| Regulatory Oversight | Regulated as securities by the SEC and FINRA | Primarily regulated by state insurance departments |
The primary point of confusion often arises because both are annuities, providing tax-deferred growth and potential income streams. However, the investor in a variable annuity assumes market risk in exchange for higher growth potential and flexibility in investment choice, whereas a fixed annuity offers predictable, guaranteed growth and principal protection, albeit with lower return potential.
FAQs
Q: Are variable annuities suitable for short-term savings?
A: No, variable annuities are generally not suitable for short-term savings goals. They are designed for long-term investment, typically retirement, and often come with substantial surrender charges if funds are withdrawn too early6.
Q: How are variable annuities taxed?
A: Variable annuities grow on a tax-deferred growth basis, meaning you don't pay federal taxes on the income and investment gains until you make a withdrawal or receive income payments5. Withdrawals are taxed as ordinary income, not at potentially lower capital gains rates, and withdrawals before age 59½ may be subject to a 10% federal tax penalty.4
Q: What are "subaccounts" in a variable annuity?
A: Subaccounts within a variable annuity are investment options, similar to mutual funds, where your premium payments are allocated. Their performance directly affects the value of your variable annuity contract.3 You choose how your money is invested among these options, which can include stock, bond, or money market portfolios.
Q: Do variable annuities offer guaranteed returns?
A: The investment portion of a variable annuity does not offer guaranteed returns; its value fluctuates with the performance of the chosen subaccounts, meaning you can lose money.2 However, many variable annuities offer optional guarantees (called riders), such as a guaranteed minimum death benefit or guaranteed minimum withdrawal benefits, for an additional fee.
Q: Can I lose money in a variable annuity?
A: Yes, you can lose money in a variable annuity. Since the value of your contract is tied to the performance of the underlying mutual funds or subaccounts you choose, if those investments perform poorly, your account value will decrease.1