Variable Annuities Explained
Variable annuities are the most complex type of annuity to understand, but with a little work, you should be able to get a basic grasp of how they operate. They are primarily used in long-term financial planning as a method to both save for your retirement and to grow those savings over time.
What Is a Variable Annuity?
Variable annuities are primarily used in long-term financial planning as a method to both save for your retirement and to grow those savings over time. Like other types of annuities, they can be structured to provide you with a guaranteed income for life. Variable annuities allow the contract owner to invest in both fixed-income and stock-based accounts. The value of these variable annuity accounts will change depending on the performance of the investments underlying the accounts.
Variable annuities are attractive to some because of the potential for higher long-term returns over fixed annuities. But the payouts of variable annuities will fluctuate, sometimes dramatically, from year to year. Unlike fixed annuities, the contract holder of a variable annuity assumes all the risk.
Note: variable annuities are investment vehicles regulated by the US Securities and Exchange Commission (SEC) because investment options are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.
- Returns tied to mutual fund performance — market risk applies
- Three benefits: income for life, death benefit, tax deferral
- Accumulation phase (5–20 years) followed by payout phase
- Regulated by the US Securities and Exchange Commission
- Surrender fees typically apply in the first 5–8 years
- Best for long-term investors comfortable with market risk
How Variable Annuities Work
There are two phases to a variable annuity: the accumulation phase and the payout phase. During the accumulation phase you make either a lump-sum payment, or a series of payments, for a period of time specified in the contract — this could be 5, 10, or even 20 years.
At the end of the accumulation phase, you can structure the annuity to either pay out entirely or to act as a simple lifetime annuity. This is the payout phase. When you establish your variable annuity, the money is invested into subaccounts — funds similar to mutual funds that invest in stocks, bonds, and money market instruments.
You can monitor each account individually. If one account is under-performing, you can move funds into the account that is performing up to your expectations. However, depending on the financial institution you choose, there will be fees and charges within the annuity — including a mortality and expense risk charge (typically around 1.25% per year as an example), administrative fees, and any special rider costs.
- Define your accumulation phase: 5, 10, or 20 years
- Choose how funds are invested across subaccounts
- Example: 30% bonds / 30% stocks / 30% money market / 10% fixed interest
- Move funds between accounts if one under-performs
- Keep it simple — fewer added benefits means lower fees
The Core Benefits of a Variable Annuity
You can structure a variable annuity to provide guaranteed income for life during the payout phase — ensuring you never outlive your retirement savings.
The death benefit gives your beneficiary at least the value of your annuity upon your death — at a minimum the present value including gains, minus withdrawals and fees.
You don’t pay taxes on a variable annuity until you begin to draw income from it. This can be advantageous if you are a high earner but will be in a lower tax bracket when you retire.
Who Benefits Most From a Variable Annuity
If you are looking for guaranteed income security with the potential to grow your savings over time, and the death benefit is of real value to you, then a variable annuity might be the right type of annuity for you. Many states protect the assets held in a variable annuity from creditors — making them popular with professionals who have a job that exposes them to legal or financial liability.
Variable annuities are best for long-term investors. You need to be well prepared and go into a variable annuity only as a long-term financial investment. You should only consider purchasing an annuity if you have fully funded your IRA, 401(k), or 403(b) for the year.
- ✓ Have a higher risk tolerance and a long investment horizon
- ✓ Have already fully funded your IRA or 401(k) for the year
- ✓ Want guaranteed income for life with growth potential
- ✓ Value a death benefit for your beneficiaries
- ✓ Are in a high income tax bracket now but expect lower rates at retirement
- ✓ Are a professional seeking creditor protection on retirement assets (laws vary by state)
Pros and Cons of Variable Annuities
Variable annuities offer real long-term benefits — but they carry meaningful risks that every investor should understand before committing.
- Potential for higher long-term returns than fixed annuities
- Income for life — guaranteed payout option in retirement
- Death benefit protects your beneficiaries
- Tax-deferred growth — no taxes until you draw income
- Ability to move funds between subaccounts to adapt strategy
- Creditor protection in many US states (laws vary)
- Market risk — you can lose money if underlying funds underperform
- Fees: mortality & expense risk charge (typically around 1.25%/yr as an illustrative example), admin fees, rider costs
- Surrender fees apply if you withdraw early (typically 5–8 years)
- Payouts fluctuate — not a predictable income stream like a fixed annuity
- Regulated by the SEC — requires reading and understanding a prospectus
- Early withdrawal before age 59½ incurs an extra 10% IRS tax penalty
Variable Annuity FAQ
A prospectus is a formal set of documentation on what the mutual fund is designed to do, how it’s invested, and how it’s managed. Because variable annuities are invested in mutual funds, you will receive a prospectus. These documents can be difficult to understand — a trusted financial advisor can help you interpret the more complicated sections. It is very important that you study the prospectus carefully so you understand the risks involved.
Yes. Unlike fixed annuities, the contract holder of a variable annuity assumes all the investment risk. Many variable annuities offer a guaranteed minimum interest rate, but some do not — and you can lose money if the underlying funds underperform. Make sure you understand everything before signing.
Surrender fees are penalties you pay if you withdraw funds before a specified time period. Often this is a diminishing percentage each year — for example 8% in the first year, 7% in the second, and so on down to zero after 8 years. Most variable annuities do allow you to withdraw a percentage of your gains each year without penalty.
Variable annuities are tax deferred — you don’t pay taxes until you begin to draw income. When you do withdraw, you pay taxes as normal income. If you are younger than 59½ years old, you will pay an extra 10% IRS tax penalty. The taxation issues involved can be complex and will require professional advice.
Fees typically include a mortality and expense risk charge (usually around 1.25% of the fund value per year as an example), administrative fees (either a yearly charge or a small percentage), and any additional costs for special riders or features you choose to include. Generally, the fewer added benefits you include, the lower your fees.
No. A variable annuity is an insurance contract that invests in subaccounts similar to mutual funds. The key differences are the annuity wrapper’s tax deferral, the death benefit, the income-for-life option, and the associated fees. Variable annuities are regulated by the SEC.