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Variable Annuity

Updated on March 27, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Variable Annuity Definition

A variable annuity is a contract between a person and the insurance company and also serves as a tax-saving investment with the insurer, which has multiple benefits with regards to the periodic payments at the time of retirement and also the death benefit to the beneficiary in case the person dies before the expiry of the contract.

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The investment option for variable annuities is typically mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more that, in turn, invest in the equity markets, thereby providing higher returns to the investors than the fixed annuity plans. These plans offer a lifetime income opportunity to those who invest in these schemes.

Key Takeaways

  • A variable annuity is a contractual arrangement between an individual and an insurance company. This arrangement provides potential tax advantages, periodic retirement payments, and a death benefit for beneficiaries in the event of the investor’s passing before the contract maturity.
  • Variable annuities commonly offer investment options in mutual funds, which are vehicles that invest in the stock market. As a result, investors may anticipate the potential for higher returns compared to fixed annuity options.
  • Variable annuities are investment products where returns are subject to market fluctuations. 

How Does Variable Annuity Work?

A variable annuity, as the name suggests, is a plan that increases or decreases in value based on the performance of the market. It is a contract between an insurance company and an individual or other party whereby the former agrees to pay periodic payments. The payments can either be made instantly or at a future date.   It can be availed either by a lump sum payment or a series of payments over the years.  A variable annuity is different from a fixed annuity, which promises fixed payments to the investor holding the instrument at the time of retirement and after that.

These annuity plans offer investors a range of options in selecting an investment strategy. Accordingly, the value of the variable annuity contracts also changes depending upon the investor’s risk. These annuities operate in two phases – the accumulation phase and annuitization phase.

The former is where one makes a purchase payment. This payment reaching the account may be less, given the fee or commission being deducted from the total purchase payment. This amount is further invested in different securities or instruments, including mutual funds. The beneficiary has the right to select the investment option. The latter, i.e., the annuitization phase is the payout phase. In this phase, one can opt to annuitize the contract and opt to receive periodic payments as regular income.

Characteristics

There are three main important features of these schemes, which include the insurance benefit, tax savings for the investor, and the periodic income stream generated.

  • These schemes give individuals a chance to have a periodic income. It helps them have a regular stream of income in exchange for whatever they have been paying to the insurer for long.
  • The next feature is that these plans are tax-deferred and hence helps individual save on taxes. There is no tax levied on the investment or income until the individuals do not withdraw the amount.
  • There are death benefits. This means when the insured dies, the insurer continues paying the nominees.

Examples

Let us consider the following examples to understand the variable annuity definition even better:

Example #1

Let’s assume that a person wants to invest $10,000 in a variable annuity with the insurance company. In this case, the company will offer the investor the plans/strategies to invest the client’s money. The investor needs to select the plan, and accordingly, the value would be decided depending upon the risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more of the fund. Since it is a variable annuity plan, the value of the investment may vary daily. Some plans may invest 70% of the funds into equity, and 30% into debt, while some may invest 50% into equity, 30% into debt, and 20% into mutual funds.

Example #2

Suppose a person invests $10,000 in a variable annuity plan, which invests 50% into debt and balances 50% into equities. The debt investment provides a return of 10%, whereas the equity investmentEquity InvestmentEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value.read more provides a return of 15%. It gives the investor returns higher than the fixed instrument provided by the Fixed Annuity plans, which generally are equal to the fixed deposit rate provided by the banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more. In this case, the investor’s investment portfolio would be valued at $12,500 due to the upside in the instruments.

Fees

The tax-deferred variable annuity refers to the fees and expenses set up by the regulators in the interest of the investors and the fund. In the case of a variable annuity plan, who has an expense ratio and a surrender charge of 5% for pre-mature withdrawals will take down the value of the investment.

E.g., Mr.A has invested $10,000 in a variable annuity with an insurance company. The surrender charge is 5% after one year. If the person tries to withdraw all the money after one year, $10,000*5% = $500 would be deducted from his payout, and he will be remitted a sum of $9,500 only into his account.

  • Fees can also be in the form of expenses charged by the regulators and other charges, such as AMC charges, fund expenses, etc.
  • The insurer may also deduct the administration charges of the fund to run the fund smoothly.

Pros & Cons

A variable annuity plan, undoubtedly, offers a lifetime income source to individuals after retirement and becomes a financial shield for them in exchange for the premiums they pay. However, these schemes are not devoid of demerits. There are limitations that one must know of before starting to invest in these annuity plans.

When the merits and demerits are known, planning becomes easier and more accurate. Let us check out the advantages and disadvantages of these annuity schemes:

Advantages

Disadvantages

  • The major disadvantage is the death of the investor since the insurer will have to give the beneficiary of the insurer the guaranteed minimum amount even if the total investment made in the account is more than the market value.

Variable Annuity vs Fixed Annuity

Annuities exist in various forms, two of which include a variable annuity and a fixed annuity. Let us check out the differences between the two:

  • A variable annuity is an investment concept that is variable or fluctuating in value. On the contrary, a fixed annuity, as the name implies, remains fixed in value no matter how worst or best the market scenario is.
  • The former, being vulnerable to market fluctuations, gives individuals an opportunity to have a possibility of obtaining higher returns than expected, while the latter promises only what has been fixed.
  • The variable annuities, being subject to market fluctuation, when affected by deteriorating market conditions, offer lower benefits than expected. On the contrary, the fixed annuity returns still remain fixed, unaffected by the deteriorating market conditions.

Frequently Asked Questions (FAQs)

1. What are the risks associated with variable annuities?

Variable annuities carry certain risks due to their investment component. The value of investments within variable annuities can fluctuate based on market performance, potentially leading to losses. Unlike fixed annuities, which offer guaranteed returns, variable annuities are subject to market volatility. 

2. Why is it called a variable annuity? 

The term “variable” in variable annuity refers to the fact that the returns generated by the annuity’s investment component are not fixed but can vary based on the performance of the underlying investments, typically mutual funds. Unlike fixed annuities that offer a guaranteed rate of return, variable annuities allow investors to participate in potential market gains subject to fluctuations.

3. What is the relevance of variable annuity?

Variable annuities are relevant for individuals aiming to combine investment growth with retirement security. They offer a unique package of benefits, allowing investors to allocate funds among diverse investment options such as stocks and bonds, potentially leading to higher returns. Crucially, they provide the option to convert accumulated value into a guaranteed stream of lifetime income, offering retirees financial stability while also offering a death benefit for beneficiaries.

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