Variable annuities are a type of investment product designed for retirement savings. They allow investors to allocate funds to a selection of sub-accounts, which can include various asset classes such as stocks, bonds, and money market funds. The performance of these sub-accounts is subject to market fluctuations, meaning returns can vary and may lead to higher potential gains or losses. Unlike fixed annuities, variable annuities do not guarantee returns, making them a riskier but potentially more rewarding investment option.
Components of Variable Annuities
Sub-Accounts
Sub-accounts are akin to mutual funds managed by professionals. They offer different investment options such as equity funds, bond funds, or money market funds. The performance of these sub-accounts directly impacts the value of the investor’s annuity.
Guaranteed Death Benefit
Despite the lack of guaranteed returns, variable annuities often include a guaranteed death benefit. This means that upon the death of the annuity holder, the beneficiaries are guaranteed a certain minimum payout, often the total amount invested minus any withdrawals.
Riders
Investors can purchase additional features known as riders for an extra fee. Common riders include:
- Guaranteed Minimum Income Benefit (GMIB): Guarantees a minimum lifetime income regardless of market performance.
- Guaranteed Minimum Accumulation Benefit (GMAB): Ensures the account value will be at least a minimum amount after a specified period.
- Guaranteed Lifetime Withdrawal Benefit (GLWB): Allows for withdrawals for life, even if the account balance falls to zero.
How Variable Annuities Work
Accumulation Phase
During the accumulation phase, investors contribute funds to the annuity. These contributions can grow tax-deferred, allowing the investment to compound more rapidly.
Payout Phase
In the payout phase, the accumulated funds are converted into a stream of periodic payments, either for a fixed time period or for the remainder of the investor’s life.
Pros and Cons
Advantages
- Potential for Higher Returns: Participation in sub-accounts that may outperform traditional fixed-income investments.
- Tax-Deferred Growth: Earnings grow tax-deferred until withdrawn.
- Death Benefits: Provides financial protection for beneficiaries.
Disadvantages
- Market Risk: Subject to market volatility.
- Fees and Expenses: Generally higher fees compared to other investment options, including management fees and rider costs.
- Complexity: Can be more complex and harder to understand.
Historical Context
Variable annuities first emerged in the United States in the 1950s as a way to provide a flexible alternative to fixed annuities, catering to investors willing to endure higher risk for potentially higher rewards. They gained popularity in the 1980s and 1990s with the advent of more sophisticated investment options.
Applicability
Variable annuities are typically suited for investors with a higher risk tolerance and a longer investment horizon. They are often used as part of a diversified retirement strategy, providing an additional income stream beyond other retirement accounts such as 401(k)s and IRAs.
Comparison with Fixed Annuities
| Feature | Variable Annuities | Fixed Annuities |
|---|---|---|
| Returns | Market-dependent | Fixed or index-linked |
| Risk | Higher | Lower |
| Fees | Higher | Lower |
| Income Guarantees | Options available through riders | Usually guaranteed |
Related Terms
- Fixed Annuity: An insurance product that guarantees a fixed interest rate on invested funds.
- Indexed Annuity: An annuity that credits interest based on the performance of a specified index, such as the S&P 500.
FAQs
What Is a Variable Annuity?
Are Variable Annuities Risky?
Can You Lose Money in a Variable Annuity?
When Should I Consider a Variable Annuity?
References
- U.S. Securities and Exchange Commission. “Variable Annuities: What You Should Know.” https://www.sec.gov/investor/pubs/varannty.htm
- Financial Industry Regulatory Authority. “Variable Annuities.” https://www.finra.org/investors/insights/variable-annuities
Summary
Variable annuities are investment vehicles that allow for the allocation of funds into various sub-accounts, creating an opportunity for higher potential returns but also bringing market risk into the equation. They offer features like tax-deferred growth and optional riders for additional guarantees, making them a complex but potentially rewarding component of a diversified retirement plan.
