All about variable annuities
One of the downsides of fixed income annuities is that the fixed income stream they provide does not keep up with inflation.
This was especially problematic in the early 1950s. In 1951, year over year inflation ranged from 6 percent to 9 percent. Although it moderated for the remainder of the decade, the high inflation that year caused concern about fixed income pension plans. Had inflation continued at the 6 to 9 percent rate, the cost of goods and services would have doubled in 9 to 12 years. That meant pensioners with fixed income streams would have lost half their buying power in a decade.
The Teachers Insurance and Annuities Association – College Retirement Equity Fund (TIAA-CREF) addressed this problem. It introduced the first variable annuity in the United States in 1952. Rather than settling for a fixed rate of interest and a fixed income stream, a variable annuity offers the opportunity to invest in stocks, bonds and other securities in the hope of earning a higher return. The idea behind the variable annuity was to prevent inflation from minimizing the value of pension payments.
How variable annuities work
A variable annuity, like all annuities, is a contract with an insurance company. You make a single payment or a series of payments to the company. You then direct the company to invest those funds in one or more sub-accounts, which are mutual-fund like investments. Like mutual funds, these sub-accounts offer different investment options in stocks, bonds, money market funds, and other securities. The number and variety of sub-account options will vary by company.
The money in those sub-accounts will increase or decrease over time, depending on their performance. You can typically transfer funds between investment options.
Variable annuities charge annual fees that may total 3 percent or more of the account value. These include a mortality and risk expense charge, an administrative fee, and expenses imposed by the funds within the sub-accounts. There will also be fees for any optional benefits (see below).
Variable immediate annuity vs variable deferred annuity
You can purchase a variable immediate annuity if you need income right away. Or you can buy a variable deferred annuity to take income after you’ve owned it for several years.
With an immediate variable annuity, your income will vary based on the value of your sub-account. That means the investment performance will determine your monthly income.
If you defer your income stream for several years, there will be an accumulation phase and a payout phase. During the accumulation phase, the sub-accounts grow tax-deferred, depending on the performance of the underlying investments. You will be required to leave most or all of the money in the annuity for at least a set period of time before you can take withdrawals.
When it comes time to take income, you can choose a lump sum of your sub-account value or a stream of periodic payments. With the stream of payments, you can choose how long you want to receive income, be it for a set number of years or for your lifetime. Also, if you opt for a stream of payments, the money remaining in your sub-accounts will continue to grow or lose value, depending on the performance of those funds. Your contract may also permit you to receive a fixed number of payments for the entire payout phase, or payment amounts that vary based on investment performance.
Free withdrawals and surrender charges
If you purchase a deferred variable annuity, the insurance company will require that you keep your money in the contract for a set number of years. This will be determined before you purchase the annuity. The length can range from 3 to 15 years.
If you decide to remove some or all of your money from the annuity before that set period, you will likely have to pay a surrender charge. This is typically a percentage of the amount withdrawn. The percentage will decline over time. For example, your annuity may have an 8 percent surrender charge if you withdraw funds in the first year, a 7 percent charge in year 2 and a 6 percent charge in year 3.
Many annuities, however, offer a free withdrawal percentage. This provision allows you to take out a percentage of the annuity’s value without a charge. A typical free withdrawal amount is 10 percent of the account value.
Variable annuities vs 401(k)s and IRAs
Although variable annuities don’t offer pre-tax contributions, one of the advantages variable annuities have over 401(k)s and IRAs is that there are no contribution limits. IRS regulations limit the amount you can contribute to a 401(k) or IRA each year, but no such limit exists for annuities. That makes them an attractive alternative for people who want to save a large amount for retirement, perhaps because retirement is just around the corner. They are also popular with individuals who have already maxed out their 401(k) and IRA contributions and want to save more for retirement on a tax-deferred basis.
Variable annuities vs fixed annuities
Variable annuities are the riskiest type of annuity contract you can buy. Although they offer a greater potential income than fixed annuities, variable annuities do not guarantee your principal, interest, or income amount.
How variable annuities are taxed
Money deposited in a variable annuity grows tax-deferred, so that taxes on investment gains are not due until a withdrawal is made. Because of this, you must wait until age 59 1/2 to withdraw funds from the annuity. Doing so prior to age 59 1/2 will result in a tax penalty. The percentage of your withdrawal resulting from investment gains is taxed as regular income; it is not treated as capital gains like other investments.
Optional features and benefits
Insurance companies offer some options to these products to make them more flexible, including:
Guaranteed income rider. For an additional fee, you can guarantee a minimum amount of income from the annuity, regardless of the investment performance.
Death benefit. This is a common variable annuity feature. If you die, your beneficiary will receive the greater of the money in your account, or a guaranteed minimum (such as all purchase payments minus prior withdrawals).
Premium bonus. Some companies offer a bonus at the beginning of the contract, typically 1 percent to 5 percent of the amount of premium you pay. So if you put $100,000 into a variable annuity with a 5 percent premium bonus, your contract will begin with a value of $105,000, minus fees and expenses. Keep in mind that fees and expenses may be higher with a premium bonus product than with a regular annuity.
No surrender charges. Some annuities offer contracts with no surrender periods, which means no charges for withdrawing money. However, the fees for these annuities will be higher than for those with surrender periods.