A variable annuity is structured to be a retirement annuity, into which is integrated several additional features. The annuity usually offers a death benefit, under which the beneficiary of the investor is paid a certain amount (usually the greater of the amount thus far accumulated in the account or a guaranteed minimum) if the investor dies prematurely. Also, any investment income earned under the annuity plan is tax deferred until such time as the investor is paid (presumably at a much later date). The investment vehicle underlying the variable annuity is packaged with an insurance contract that is activated if there is a loss in capital, thereby protecting some or all of the investor's investment.
Variable annuities are offered by insurance companies under an arrangement where an investor, who is planning for retirement, invests either a lump sump or a series of invested amounts with the insurer, who then invests the money and agrees to provide a variable annuity to the investor in exchange.
A variable annuity can be structured in many ways, such as:
- There is a guaranteed minimum payment, with a variable additional amount that is based on the return from the underlying investment pool.
- There is no guaranteed payment, with the entire amount of the payment being derived from the return on an underlying investment pool.
- The investor has the option of being paid in an annuity format over a fixed period of time, or of withdrawing variable amounts at variable intervals (or all at once).
- The investor can choose the payout period, such as larger payments over a short period, or smaller payments over a longer period.
Variable annuities are generally not recommended, for three reasons:
- Fees. This type of annuity is overloaded with both commission fees and ongoing account administration charges, which severely offset any investment gains. Further, each additional benefit built into the plan, such as the death benefit, is based on an integrated insurance plan that you are also paying for.
- Termination. There are large termination fees that effectively lock up funds for a minimum of five years. You can still terminate the arrangement before that time, but only by paying a charge that can exceed 6% of the invested amount.
- Taxes. Gains on a variable annuity are taxed at the ordinary income tax rate, which is higher than the long-term capital gains rate.
Because of the preceding issues, it is almost always more cost-effective to maximize your investment in a 401(k) pension plan and an IRA before placing any funds in a variable annuity.