Variable annuities are financial tools that allow annuitants to invest in sub-accounts for a higher rate of return. Because the investment value is dependent on the performance of the financial market, they carry the risk of losing interest.
What Is a Variable Annuity?
A variable annuity is a type of annuity that is dependent on another financial entity’s performance. An annuity is a financial contract that protects financial assets and provides a steady income stream. Because of its extensive benefits and potential for long-term growth, lottery recipients and working professionals looking to invest in their nest egg frequently use annuities to secure their financial futures.
Variable annuities can potentially earn interest, but also incur risk, because they are partially invested in mutual funds, stocks, bonds or other financial markets. This option offers a potentially higher rate of return than the other major type of an annuity, a fixed annuity.
Both fixed and variable annuities offer guaranteed payout streams and a form of financial security, but they differ in how interest is accrued. Unlike a variable annuity, a fixed annuity guarantees the monthly or yearly payment an annuity owner (annuitant) receives is consistent. This annuity option offers a set interest rate of return, and does not fluctuate every pay period. With a variable annuity, however, the amount an annuitant receives every pay period may fluctuate because the interest rate depends on the fluctuating financial market.
How Do Variable Annuities Work?
Variable annuities are financial investments similar to a mutual fund in the sense that issuers can manage annuity funds through stocks an annuitant chooses to invest in.
When you buy a variable annuity, either through lump sum or monthly premium payments, the payments are invested into sub-accounts. Depending on how each investment performs, the premium amount of the annuity may increase or decrease.
Though the interest rate may fluctuate according to the climate of the financial market, a variable annuity still guarantees a payout. Owners can also elect to have a death benefit as a part of their contract. A death benefit ensures a beneficiary or heir receives the remaining annuity funds upon the annuitant’s death. Without a death benefit, any remaining assets are forfeited to the insurance company.
Variable Annuity Types: Immediate vs. Deferred
The two types of variable annuities are immediate annuities and deferred annuities. While both options guarantee a steady income stream, they differ in how the payout is disbursed.
Immediate annuities provide immediate access to the financial disbursement. The payout begins promptly after the contract is established. In this case, an annuitant would pay for the contract in lump sum, and in return would immediately begin receiving income payments.
Conversely, deferred annuities provide income at a later date, as established within the annuity contract. There are two main options available for a deferred annuity:
- Single-Premium Deferred Annuity – An annuitant pays a one-time lump sum for this variable annuity contract.
- Periodic-Payment Deferred Annuity – An annuitant makes gradual premium payments for this annuity contract until the annuitization date, or date in which the annuity begins paying out to the annuitant.
Variable Annuity Pros and Cons
As with any investment, it is important to weigh the benefits against the risks of a variable annuity. There are a number of benefits from investing in a variable annuity. Some of the major pros of this financial contract include:
- Guaranteed Payout – No matter the state of the financial market, variable annuity owners are guaranteed to receive annuity payments through the end of the annuity term or until their death, though the amount may fluctuate per pay period according to the performance of the invested sub-accounts. If the annuity owner dies before the end of the contract term and they have a death benefit, the remaining funds will be transferred to a beneficiary.
- Growth Potential – Variable annuities allow annuitants the opportunity to invest in sub-accounts, providing ample long-term growth potential. If the investment performs well within the financial market, the interest can increase.
- Tax-Deferred Growth – Variable annuity investments are tax-deferred. Therefore, any interest earned on top of the annuity savings are not taxed until they are withdrawn from the contract.
- Death Benefit – Variable annuity owners can choose to include a death benefit within their contract, ensuring any remaining annuity funds left after their death are passed on to an heir. Should the interest or investment decrease in value from poor financial market performance, the beneficiary is guaranteed to receive no less than the initial investment. A contract without a death benefit risks forfeiting any remaining assets to the issuing insurance company.
On the other hand, variable annuities carry a number of drawbacks. Some cons of investing in this type of annuity include:
- Surrender Charges – If an annuity owner chooses to break the variable annuity contract before the end of the term, they will be charged surrender fees. Though fees differ from one insurance company to the next, in some cases it can be more expensive to cancel the contract and pay surrender fees than to continue with annuity premium payments.
- Excess Expenses – Variable annuities carry a number of additional fees required to maintain the contract. Some of these fees include management fees, administrative fees and mortality fees. Annuitants also risk being charged withdrawal fees if they decide to use a portion of their variable annuity investment prior to the payout phase.
- Investment Risks – Though variable annuities offer the opportunities for long-term pay increase, they carry a major risk. If the sub-accounts you choose to invest in perform poorly, you risk losing a portion of your investment and a lower payout.
- Inflexibility – Once contract terms are finalized for variable annuities, they cannot be altered. This is specifically true for the annuitization phase.
Selling Your Variable Annuity
To some, one of the biggest drawbacks of a variable annuity is the investment risk from potential sub-accounts. While investing in an annuity can be a profitable decision, financial needs can change over time. If you decide owning a variable annuity is no longer right for you, CBC Settlement Funding can help. With an A+ rating from the Better Business Bureau and experience in the financial industry as an annuity purchasing company, CBC Settlement Funding can be your solution to financial debt.
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