Define: Variable Annuity

A variable annuity is an annuity whose value fluctuates in response to market changes. It is designed to be a retirement annuity with several additional features built in. If the investor dies prematurely, the beneficiary of the annuity is usually paid a certain amount (usually the greater of the amount thus far accumulated in the account or a guaranteed minimum). Furthermore, any investment income earned through the annuity plan is tax-deferred until the investor is paid (presumably at a much later date). The variable annuity investment vehicle is packaged with an insurance contract that kicks in if there is a capital loss, thereby protecting some or all of the investor’s investment.

Insurance companies offer variable annuities under an arrangement in which an investor planning for retirement invests either a lump sum or a series of invested amounts with the insurer, who then invests the money and agrees to provide the investor with a variable annuity in exchange.

Variable annuities can be structured in a variety of ways. One option is a guaranteed minimum payment with a variable additional amount based on the underlying investment pool’s return. Another option is to have no guaranteed payment, with the entire amount derived from the return on an underlying investment pool. Another option is for the investor to be paid in an annuity format over a set period of time, or to withdraw variable amounts at variable intervals (or all at once). The investor may also be able to select the payout period, such as larger payments over a shorter time period or smaller payments over a longer time period.

Variable annuities are not recommended in general for three reasons. For starters, this type of annuity is laden with both commission fees and ongoing account administration fees, which significantly offset any investment gains. Furthermore, each additional benefit built into the plan, such as the death benefit, is based on an integrated insurance plan for which you also pay. Second, there are significant termination fees that effectively lock up funds for at least five years. You can still cancel the agreement before that time, but only if you pay a fee that exceeds 6% of the amount invested. Third, variable annuity gains are taxed at the ordinary income tax rate, which is higher than the long-term capital gains rate. Because of these concerns, it is almost always more cost-effective to invest in a 401(k) pension plan and an IRA before investing in a variable annuity.