What is a variable annuity?

An annuity is a contract with an insurance company (“insurer”) for the purpose of accumulating money while deferring the taxes incurred, with the goal of having that money fund regular monthly payments to an annuitant, generally at some point in the future.

Some annuities, called fixed annuities, earn interest at a rate declared by the insurer (“equity index annuities” are fixed annuities whose interest rate is based on a market index such as the S&P 500). A variable annuity (“VA”) is an annuity where the funds are invested, usually in stocks or mutual funds, with the actual investments chosen by the owner from choices presented by the insurer.

Significant growth potential

The potential for significant growth in a bull market is clear – the more the market rises, the more the value of the contract owner’s VA. Because taxes are deferred until funds are actually withdrawn from the VA, the actual rate of growth will be much faster than if the funds were maintained in a regular brokerage account. While a fixed annuity shares the tax-preferred status of a VA, it won't benefit from a strong bull market except to the extent that the insurer elects to reflect a long-term bull market in its declared rates.

Other Advantages and Disadvantages

Variable annuities share most of the advantages of fixed annuities such as tax-deferred growth, annuitization (the opportunity to convert to a guaranteed monthly income for life), protection of annuity payments from creditors, and protection of all funds from the probate process. They also share the disadvantages, such as the years-long surrender period during which withdrawals above a certain amount are subject to a significant penalty, and the punitive tax treatment of annuity earnings when the owner dies. (While some would include commissions, high costs and fees among the disadvantages of all annuities, some insurers pay these costs from their own funds, so it’s a drawback not applicable to all annuities.)

Risk not Shared by Other Annuities

A drawback of VA’s not shared by fixed annuities is that the principal amount is not protected – indeed, a variable annuity is the only kind of annuity in which the contract owner can actually lose money. While it’s true that all equity investing bears this risk, and is a hallmark of the capitalist system, there are some areas where consumers are naturally more risk averse, such as retirement planning, especially as they grow older. Thus, most financial professionals won’t recommend VA’s for people over 50 or even 45, preferring to see people that age park their retirement money in safer instruments like fixed annuities and equity indexed annuities, even at the expense of potentially higher returns.

Annuities and Retirement Planning

These advantages and disadvantages, taken together, generally make fixed annuities (and the related equity indexed annuities) excellent vehicles for accumulation of cash during one’s earning years, and then used to provide income during retirement. Risk tolerance in this scenario, never very high, decreases as the owner approaches retirement age. Variable annuities, then, because of the possibility of loss of principal, are not a good component of a retirement planning portfolio.

Loss Prevention Strategies

To address the concerns about loss of principle, insurers offer some interesting options, such as the death benefit. This option, available for a fee, guarantees that if the owner dies before the VA’s maturity, the named beneficiary will receive at least the amount of the initial investment, less any withdrawals made, and any routine fees and charges. While this option at least ensures that the beneficiary will receive at least as much as was paid into the VA, the reality is that even if invested in a bank CD, the funds would have appreciated.

Insurers also offer bonuses on some of their annuities, including VA’s. Bonuses are credited in different ways, however. Some annuities credit the bonus to the principal amount either immediately upon the account’s inception, or at the end of the first year. (Many insurers require that bonuses be vested, so that the bonus amount is reduced if early withdrawals are taken.) Some insurers, however, only implement the bonus when the account is annuitized, crediting either the principal amount or the amount of the monthly annuity payment.

Another “tweak” some insurers make to their VA’s is to offer a minimum guaranteed interest amount, claiming that even if the market declines, the annuity won’t actually lose principal. (Equity index annuities work this way, adjusting the account value only for positive changes in the index underlying the annuity.) What’s not usually made clear to the purchaser is that the minimum is applied only at the point of annuitization – if the annuity is never converted to the guaranteed income stream, then the minimum interest rate is never applied to the annuity, and the owner can lose the entire principal amount.

Consumers should exercise due diligence when considering the purchase of any financial product, especially those in which their principal is fully at risk, such as a variable annuity. Precautions against loss that are implemented only in the event of annuitization should be viewed especially warily, because of all the annuities sold in the US, less than ten percent are ever annuitized.