Is a Variable Annuity Right for Me?
A variable annuity may fit a retirement plan if you have a long time horizon, can accept market risk, understand the contract’s fees and withdrawal limits, and value its insurance or income features. It may be less suitable when you need short-term access to money or already have similar tax-deferred accounts.
Key Takeaways
- A variable annuity is an insurance contract with investment options, not simply a mutual fund.
- Subaccount values can rise or fall, and you can lose some or all of the amount invested.
- Fees may include insurance, administration, underlying fund and optional-benefit costs.
- Guarantees depend on the contract and the issuing insurer’s claims-paying ability.
- Suitability depends on time horizon, liquidity, tax situation, risk tolerance and your overall retirement plan.
Table of Contents
- What Is a Variable Annuity?
- How Does a Variable Annuity Work?
- Variable Annuity Pros and Cons
- Understanding Variable Annuity Risks
- Variable Annuity Fees and Charges
- What Variable Annuity Guarantees May Include
- Variable Annuity vs. Mutual Funds
- Tax Considerations and Early Withdrawals
- Is a Variable Annuity Right for Your Retirement Plan?
- What to Review Before Buying a Variable Annuity
- Frequently Asked Questions
What Is a Variable Annuity?
A variable annuity is an insurance contract between an individual and an insurance company. It allows the contract owner to invest money through a selection of investment options, typically called subaccounts, whose values fluctuate according to the performance of their underlying investments.
These investment options commonly resemble mutual funds and may invest in stocks, bonds or money market instruments. However, a variable annuity is an insurance contract rather than a direct investment in an ordinary mutual fund.
A variable annuity may also offer insurance-related features, including a death benefit and the ability to convert the contract value into periodic income payments. Some contracts provide additional optional benefits for an extra charge.
Variable annuities are generally designed for long-term retirement planning rather than short-term savings. Their investment performance, costs, insurance features and withdrawal restrictions can differ considerably between contracts.
Understanding what a variable annuity offers is the first step toward determining whether it may fit your retirement strategy.
How Does a Variable Annuity Work?
A variable annuity generally works through two main stages: the accumulation phase and the payout phase. Understanding both stages can help you evaluate how the contract may support your retirement goals.
1. The Accumulation Phase
During the accumulation phase, you make a single purchase payment or a series of payments into the contract. You then allocate the money among the available investment options, typically subaccounts that invest in different types of securities.
The value of your account changes according to the performance of the selected investment options, minus applicable fees and charges. If the investments perform well, your account value may increase. If they perform poorly, your account value may decrease, potentially below the amount originally invested.
In a nonqualified annuity, investment growth generally accumulates on a tax-deferred basis until money is distributed.
2. The Payout Phase
The payout phase begins when you start receiving income from the annuity. Depending on the contract, you may have the option to receive payments monthly or at other intervals over a specified period or for your lifetime.
Some contracts allow payments that vary with investment performance, while other payment options may provide a fixed amount under the contract terms.
Once annuity payments begin, access to the remaining contract value may be restricted depending on the payout option you select. This is an important consideration if you expect to need flexible access to your retirement savings.
For additional background on annuity payment timing, see ASOFSP’s guide to immediate and deferred annuities.
Variable Annuity Pros and Cons
Variable annuities offer several potential retirement planning benefits, but those benefits should be weighed against investment risks, fees and contract limitations.
Potential Benefits of Variable Annuities
- Tax-deferred growth: In a nonqualified annuity, investment earnings generally grow without current federal income tax until distributed. This may help investors who have a long investment horizon.
- Investment choices: Variable annuities generally provide access to multiple investment options, allowing contract owners to allocate money according to their investment preferences and risk tolerance.
- Retirement income options: Certain contracts allow owners to convert their accumulated value into periodic payments, potentially including payments for life.
- Death benefits: Depending on the contract, a beneficiary may receive a specified benefit if the owner dies during the accumulation phase.
- Optional insurance benefits: Some contracts offer additional living or death benefit features that may address particular retirement income or legacy planning objectives.
Potential Drawbacks of Variable Annuities
- Investment losses: The value of the contract may decline when its underlying investment options perform poorly.
- Multiple fees: Insurance charges, administration costs, investment expenses and optional benefit fees may reduce investment returns.
- Limited liquidity: Withdrawals during a surrender period may trigger additional charges.
- Contract complexity: Insurance benefits, withdrawal conditions and investment restrictions can make contracts difficult to compare.
- Insurance company risk: Contractual guarantees depend on the financial strength and claims-paying ability of the issuing insurance company.
The value of a variable annuity ultimately depends on whether its specific features justify the associated costs and limitations for your circumstances.
Understanding Variable Annuity Risks
Variable annuity risks should be carefully evaluated before committing retirement savings. Unlike products that offer a specified fixed return, the value of a variable annuity generally depends on the performance of its selected investment options.
Market and Investment Risk
The underlying investments may lose value when stock, bond or other financial markets decline. These losses can reduce the contract’s account value and the amount available for withdrawals or other benefits.
It is possible to lose some or all of the original amount invested, depending on the contract and the available protection features. A variable annuity should not automatically be treated as an investment that protects your principal.
Insurance Company Risk
Insurance-related guarantees are obligations of the issuing insurance company. Their payment depends on the insurer’s financial strength and claims-paying ability. If the company experiences financial difficulty, it may be unable to meet its contractual obligations.
Liquidity and Withdrawal Risk
Variable annuities are generally intended for long-term use. Withdrawals during the surrender period may result in charges, and taking money out can also reduce the value of certain optional benefits.
In addition, some payout arrangements significantly limit access to the remaining contract value after income payments begin.
Before investing, review the contract’s investment risks, withdrawal provisions and available benefits. The prospectus for the contract and its underlying investment options provides important information to help you evaluate these risks.
Variable Annuity Fees and Charges
Understanding variable annuity fees is an essential part of deciding whether a contract is suitable for your retirement plan. Different variable annuities can have different fee structures, and the combined expenses may affect long-term investment results.
Depending on the contract, common variable annuity fees and charges may include:
Mortality and Expense Risk Charges
These charges compensate the insurance company for certain insurance-related risks under the contract. They are generally calculated as a percentage of the contract value.
Administrative and Account Fees
Insurance companies may charge administrative fees to cover recordkeeping, account maintenance and other contract-related services. These charges may be assessed as a flat annual fee or as a percentage of account value.
Underlying Investment Expenses
The investment options within a variable annuity have their own operating expenses. These expenses are separate from the insurance company’s contract charges and reduce the returns of the underlying investment options.
Optional Benefit Fees
Additional charges may apply when you select optional features, such as enhanced death benefits or guaranteed lifetime withdrawal benefits. Consider whether these benefits provide enough value to justify their ongoing costs.
Surrender Charges
Surrender charges may apply when you withdraw money during a specified period after purchasing the contract. These charges often decline over time, but the applicable schedule and any permitted withdrawals without surrender charges depend on the contract.
Other expenses, such as sales charges or investment transfer fees, may also apply.
Before purchasing a variable annuity, review its prospectus and request a clear explanation of all applicable charges. Consider how these expenses may affect the value of your investment over the period you expect to hold the contract.
What Variable Annuity Guarantees May Include
Variable annuity guarantees may offer certain protections or income-related features, but the benefits available depend on the specific contract. Some are included in the base contract, while others are optional and require additional fees.
Death Benefits
A death benefit may provide a payment to a designated beneficiary if the contract owner dies. Depending on the contract, the benefit may be based on the current account value or a specified minimum amount, subject to withdrawals and contract provisions.
Some contracts offer optional enhanced death benefits that may provide additional protection for beneficiaries at an extra cost.
Guaranteed Lifetime Withdrawal Benefits (GLWB)
A GLWB may allow an eligible contract owner to withdraw a specified amount under the contract for the rest of their life, subject to applicable conditions. The withdrawal benefit may continue even if the actual investment account value becomes depleted, provided the contract requirements have been met.
Guaranteed Minimum Income Benefits (GMIB)
A GMIB may provide a minimum value or income calculation for annuitization under specified contract terms. The benefit is designed to provide a minimum income option even when investment performance is unfavorable.
Guaranteed Minimum Accumulation Benefits (GMAB)
A GMAB may guarantee a specified minimum contract value after a defined period, subject to the conditions and limitations of the contract.
These optional benefits are not available with every variable annuity and may involve additional fees, investment restrictions and withdrawal limitations. A guaranteed benefit base is also not necessarily the same as the account value available for immediate withdrawal.
Importantly, guarantees depend on the claims-paying ability of the issuing insurance company. They do not eliminate all market risks or automatically protect the entire investment from losses.
Before evaluating a guarantee as a reason to purchase an annuity, examine the contract language, costs and conditions required to receive the benefit.
Variable Annuity vs. Mutual Funds
Variable annuities and mutual funds may offer similar investment options, but they are different financial products. Understanding their differences can help you determine whether an insurance-based investment contract provides features that are relevant to your retirement needs.
1. Investment Structure
A variable annuity is an insurance contract that provides access to investment options, typically subaccounts investing in mutual fund-like portfolios. A mutual fund is an investment company that pools money from multiple investors to purchase securities such as stocks and bonds.
2. Insurance and Income Features
A variable annuity may offer insurance-related features, including death benefits, optional living benefits and the ability to convert the contract value into periodic income payments under specified terms.
A traditional mutual fund does not provide these insurance contract benefits or guarantee lifetime income by itself. An investor may instead combine mutual fund investments with other retirement income sources.
3. Tax Treatment
A nonqualified variable annuity generally allows investment earnings to grow on a tax-deferred basis until distribution. A mutual fund held in a taxable account may generate taxable dividends, interest or capital gains distributions during the year.
However, mutual funds held inside tax-advantaged retirement accounts follow the tax rules of those accounts. Similarly, placing a variable annuity inside an IRA or 401(k) does not provide an additional layer of tax deferral.
4. Fees and Expenses
Variable annuities may have multiple layers of expenses, including insurance charges, administrative fees, underlying investment expenses and optional benefit fees. These costs can be higher than the expenses associated with some mutual fund investments.
Mutual funds also have expenses, such as operating and management costs, but they generally do not include the same insurance contract charges.
5. Access to Your Money
Variable annuity contracts may include surrender periods and withdrawal restrictions. Mutual fund investors generally have more direct access to their investment value, although brokerage account rules, transaction costs and applicable taxes may still matter.
Neither option is automatically better. The appropriate choice depends on the investment features, insurance benefits, expenses, tax circumstances and liquidity needs involved.
Tax Considerations and Early Withdrawals
Tax treatment is an important part of evaluating a variable annuity. The rules can differ depending on whether the contract is purchased with after-tax money outside a retirement plan or held within a qualified retirement account.
Tax-Deferred Growth
For a nonqualified variable annuity, investment earnings generally accumulate without current federal income tax until money is distributed. This is known as tax-deferred growth.
However, if you purchase a variable annuity inside an IRA or an employer-sponsored retirement plan, such as a 401(k), the annuity does not provide additional tax deferral beyond the tax treatment already available through that account.
Before purchasing an annuity with money outside a retirement plan, consider whether available retirement savings opportunities, including eligible 401(k) and IRA contributions, have been appropriately addressed in your financial strategy.
How Are Variable Annuity Withdrawals Taxed?
For a nonqualified deferred annuity, withdrawals made before annuity payments begin are generally treated as taxable earnings first, followed by a return of the owner’s investment in the contract.
When periodic annuity payments begin, part of each payment may represent taxable earnings and part may represent a tax-free return of the investment in the contract. The applicable calculation depends on the contract and IRS rules.
Distributions from variable annuities held within qualified retirement accounts generally follow the tax rules applicable to those retirement accounts.
Early Withdrawal Tax Considerations
In general, the taxable portion of a distribution from a nonqualified annuity before age 59½ may be subject to an additional 10% federal tax unless an exception applies. This additional tax is separate from any surrender charges imposed by the insurance company.
Because annuity taxation can be complicated, review your contract and consult a qualified tax professional before making a withdrawal or changing your retirement investment strategy. You can also review the IRS guidance on pension and annuity income.
Is a Variable Annuity Right for Your Retirement Plan?
Determining whether a variable annuity is appropriate requires more than comparing potential investment returns. You should evaluate how the contract’s benefits, risks, costs and restrictions fit into your broader retirement strategy.
When a Variable Annuity May Be Worth Considering
A variable annuity may be worth evaluating if you:
- Have a long-term retirement investment horizon.
- Are comfortable with the investment risks associated with market-based subaccounts.
- Value specific insurance features or potential retirement income benefits.
- Understand the contract’s fees, withdrawal provisions and limitations.
- Have sufficient accessible savings for unexpected expenses outside the annuity.
- Have evaluated how the annuity fits alongside your other retirement accounts and investments.
When a Variable Annuity May Not Be Suitable
A variable annuity may be less appropriate if you:
- Need frequent or immediate access to the money invested.
- Have a short-term investment objective.
- Are uncomfortable with fluctuations in investment value.
- Cannot justify the additional insurance and contract expenses.
- Already have sufficient retirement income and do not need the additional contract features.
- Do not understand the restrictions or conditions associated with the guarantees being offered.
For example, someone who expects to use the invested money for a major expense within the next few years may find the surrender period and potential withdrawal charges difficult to accommodate. An investor with a longer retirement horizon and a specific need for certain contractual income features may have different considerations.
These are general considerations, not universal rules. A variable annuity’s suitability depends on your financial situation, available alternatives and the particular contract being evaluated.
Consider Your Broader Retirement Income Strategy
A variable annuity should not be evaluated separately from your other retirement income sources. Consider how Social Security, pensions, savings, investment accounts and other income-producing assets work together.
For additional perspective, explore ASOFSP’s guides to retirement income strategies and sources of retirement income.
The goal is to understand whether a variable annuity addresses a specific need without creating unnecessary expenses, restrictions or investment risks.
What to Review Before Buying a Variable Annuity
Before purchasing a variable annuity, review the contract carefully and make sure you understand what you are paying for. The following checklist can help organize your evaluation.
- Read the prospectus: Review the contract’s investment objectives, risks, fees, charges, benefits and limitations. Also review the prospectuses for the underlying investment options.
- Compare total expenses: Identify insurance charges, administration fees, underlying fund expenses, optional rider costs and any other applicable charges.
- Understand the investment options: Evaluate the available subaccounts, their investment objectives, risks and potential role in your overall portfolio.
- Review the guarantees: Understand what each guarantee actually protects, how it is calculated, what conditions apply and whether additional fees are required.
- Check withdrawal restrictions: Review the surrender period, applicable surrender charges, permitted withdrawals and any limitations after income payments begin.
- Consider the insurer’s financial strength: Remember that contractual guarantees depend on the issuing insurance company’s claims-paying ability.
- Evaluate tax consequences: Consider whether the contract is qualified or nonqualified and how distributions may affect your taxes.
- Compare available alternatives: Determine whether other investments or retirement income options may address the same financial needs with different costs and risks.
The SEC’s variable annuity investor guidance provides additional information about contract features, investment risks, charges and tax considerations.
Retirement Planning with ASOFSP
Choosing a retirement investment involves understanding how each financial product fits into your broader financial picture. A variable annuity may provide certain insurance and income features, but its costs and limitations should be evaluated alongside your other retirement resources.
For individuals and families in Fort Myers and Southwest Florida, a comprehensive retirement planning approach can help put investment decisions into the context of long-term financial goals, income needs and individual circumstances.
The Art and Science of Successful Planning (ASOFSP) is a fee-only fiduciary financial planning firm based in Fort Myers, Florida. Consider discussing your retirement priorities with a qualified financial professional before making a decision about a variable annuity.
Disclaimer: The information in this material is for general informational purposes only and is not intended as tax, legal or investment advice. Variable annuities involve investment risks, and contract values may fluctuate with market conditions. Fees, charges, guarantees, withdrawal provisions and tax treatment vary by contract and individual circumstances. Please review the applicable prospectus and consult appropriate tax, legal and financial professionals regarding your specific situation. The information provided should not be considered a solicitation for the purchase or sale of any security.
Frequently Asked Questions
Can You Lose Money in a Variable Annuity?
Yes. A variable annuity's value depends on the performance of its underlying investment options. If those investments decline, your account value may decrease, potentially below your original investment. Certain contractual benefits may provide specific protections, but they do not automatically eliminate market risk or guarantee the entire account value.
Do Variable Annuities Guarantee Income for Life?
Some variable annuities offer lifetime income options or optional guaranteed lifetime withdrawal benefits. However, these features are subject to the contract's terms, conditions, fees and limitations. Guarantees also depend on the financial strength and claims-paying ability of the issuing insurance company.
Are Variable Annuities a Good Investment for Retirement?
Variable annuities may be appropriate for some long-term retirement strategies, particularly when specific insurance or income features provide meaningful value. However, market risk, fees, surrender charges and tax considerations should be evaluated before investing. The suitability of a variable annuity depends on your financial goals, time horizon and available alternatives.
What Happens if You Withdraw Money From a Variable Annuity Before Age 59½?
An early withdrawal may trigger surrender charges if the contract is still within its surrender period. The taxable portion of the withdrawal may also be subject to ordinary income tax and an additional 10% federal tax unless an exception applies. The exact consequences depend on the contract, account type and applicable tax rules.
Does a Variable Annuity Provide Additional Tax Benefits Inside an IRA or 401(k)?
No additional tax deferral is generally provided by holding a variable annuity inside an IRA or 401(k), because those accounts already offer tax-advantaged treatment. A variable annuity within such an account should therefore be evaluated based on other features, such as income options or insurance benefits, and whether their costs are justified.
