Variable Annuity

Core Description

Variable annuities combine insurance with investment opportunities, providing tax-deferred growth and, with additional riders, the potential for structured lifetime income. They feature multiple layers of fees, unique tax considerations, and expose investors to market risk unless certain optional benefits are selected. Variable annuities are generally considered after other tax-advantaged retirement accounts have been maximized and when specific insurance features are required.

Definition and Background

A variable annuity is a long-term insurance contract designed to provide investors with access to a selection of investment options (typically via subaccounts that resemble mutual funds) within a tax-deferred structure. Policyholders pay premiums to an insurance company and allocate them among a range of available subaccounts, which include equities, bonds, and balanced portfolios. The value of a variable annuity and any future income is determined by the performance of these underlying investments.

Early History and Development

Variable annuities were introduced in the early 1950s, as investors sought alternatives to fixed annuities that better aligned with inflation and market developments. By pooling premiums in separately managed investment accounts, variable annuities offered growth potential linked to market performance, along with increased risk.

Regulatory oversight evolved over subsequent decades. In 1959, the U.S. Supreme Court classified variable annuities as securities, leading to dual oversight from insurance and federal securities regulators. The Tax Reform Act of 1986 maintained the tax deferral of annuity investment earnings, further integrating these products into retirement planning.

Contemporary Relevance

Variable annuities represent a tool for individuals seeking a combination of growth potential, tax deferral, and optional guarantees. With defined benefit pensions declining and life expectancies increasing, the insurance components—such as death benefits and lifetime income riders—provide alternatives to more traditional investment options within retirement portfolios.

Calculation Methods and Applications

Variable annuities combine investment management and insurance features in their operation. The following describes common calculation methods and contract applications.

Accumulation and Unit Value Calculation

• Accumulation Phase: Premiums purchase units in subaccounts. Account value is calculated as Units held × Accumulation Unit Value (AUV).
• AUV Calculation: The accumulation unit value is updated daily:
  AUV_t = AUV_{t-1} × (1 + Net Return_t)
  where Net Return_t accounts for the gross investment return, minus daily portions of mortality, expense, administration, and any rider fees.

Investment Return Calculation

Net periodic return can be calculated as:
Net Return = [(1 + Fund Return) × (1 – (M&E/k)) × (1 – (Admin Fee/k))] – 1
where M&E is the Mortality & Expense risk fee and k represents the number of periods per year.

Example:
If a variable annuity contract delivers:

• Investment return: 6 percent (gross)
• M&E charge: 1.25 percent
• Admin fee: 0.15 percent
• The annual net return would be approximately 4.6 percent before considering additional rider fees

Surrender Value and Withdrawal Charges

Early withdrawals may trigger a Contingent Deferred Sales Charge (CDSC), typically decreasing over 5 to 7 years.
Surrender Value = Account Value – CDSC – other possible charges

Death Benefit and Living Benefit Calculations

• Standard death benefit: Pays the greater of current account value or total premiums paid (adjusted for withdrawals).
• Enhanced death benefit: May use a step-up to previous highest values or include a roll-up rate.
• Living benefit riders: Lifetime income or minimum withdrawal features are based on a notional “benefit base,” which may be increased by step-ups or guaranteed roll-ups.

Use Cases

Variable annuities may be utilized by:

• Individuals who have maximized employer-sponsored retirement plans but seek further tax deferral.
• Retirees aiming for customizable income streams with some protection against inflation and downside risk.
• High-earning professionals looking for additional tax-deferred accumulation.
• Individuals focused on legacy planning where traditional life insurance is unavailable or insufficient.

Comparison, Advantages, and Common Misconceptions

Advantages of Variable Annuities

• Tax-deferred growth: Earnings are tax-deferred, potentially enabling accelerated accumulation over similar investments in taxable accounts.
• Investment flexibility: Policyholders can select from a variety of subaccounts, facilitating diversification.
• Optional guarantees: Riders may provide structured income, death benefits, or minimum accumulation benefits.
• Estate planning flexibility: Enhanced death benefits and tax deferral can support wealth transfer and inheritance management.
• Professional management: Subaccounts and automatic rebalancing are managed by professionals within the contract framework.

Disadvantages

• Relatively high costs: Fees include mortality and expense (M&E) charges, administrative fees, fund management fees, and optional rider costs, and may total 2 percent to 3 percent or more annually.
• Liquidity restrictions: Surrender charges may apply for years, limiting access to capital.
• Tax treatment: Withdrawals of gains are taxed as ordinary income, not at long-term capital gains rates.
• Market exposure: Unless specified by contract, market risk remains with the policyholder.
• Complexity: Contracts often include intricate rules for riders, withdrawals, and guarantees, which may be misunderstood.

Key Comparisons

Common Misconceptions

• Principal or returns are always protected: Only if specific riders are purchased.
• Tax-deferred earnings are tax-free: Withdrawals of gains are taxed as ordinary income, not at capital gains rates.
• Fees are comparable to mutual funds: Variable annuity fees are generally higher, which may reduce net returns in modest or flat markets.
• VAs are always optimal inside IRAs or 401(k) s: The tax-deferral feature is redundant and may offer no additional advantage unless specific contract protections are needed.

Practical Guide

Step-by-Step Approach to Considering a Variable Annuity

1. Assess Suitability and Objectives

• Determine if your primary requirement is tax deferral, longevity insurance, or structured minimum income.
• Ensure all lower-cost options (such as workplace retirement plans) have been maximized first.
• Commit only funds with a long investment horizon and no anticipated short-term liquidity needs.

2. Understand Contractual Structure and Fees

• Carefully review the contract prospectus and all supporting fee schedules.
• Pay particular attention to mortality and expense (M&E) charges, administrative and investment fees, rider costs, and surrender charge schemes.
• Evaluate overall cost, net historical returns after fees, and the insurer's financial strength before proceeding.

3. Select Investment Options

• Choose a well-diversified allocation across available subaccounts in alignment with your risk tolerance and objective.
• Avoid excessive concentration in specialized sectors unless justified by your broader portfolio strategy.
• Be aware that certain riders may impose restrictions on asset allocation to maintain benefit eligibility.

4. Evaluate the Need for Riders

• Only add riders addressing identified risks relevant to your plan.
• Fully understand each rider’s features, including roll-up rates, withdrawal limits, minimum holding periods, age restrictions, and any required asset allocations.
• Avoid unnecessary duplication of guarantees if you already have other secure retirement income sources.

5. Funding and Withdrawal Strategy

• Prioritize lower-fee, tax-advantaged accounts before funding a variable annuity.
• Consider regular contributions or dollar-cost averaging to mitigate market timing risk.
• Remain within allowed withdrawal limits—especially during surrender charge periods—to avoid penalties or the loss of guarantees.

6. Tax Planning

• Coordinate withdrawals with other income sources, recognizing that last-in, first-out (LIFO) taxation means earnings are withdrawn (and taxed) before principal.
• For sizable balances, consider consulting a fiduciary planner about withdrawal timing, contract exchanges (such as Section 1035 in the U.S.), or required minimum distributions if relevant.

7. Monitor Regularly

• Review investment performance, total fees paid, insurer credit ratings, and continued value from riders on an annual basis.
• Adjust asset allocation as personal financial needs or market conditions change.

Case Study: Hypothetical Use of a GLWB Rider for Retirement

(This is a hypothetical example, not investment advice or a depiction of an actual client scenario.)

A 62-year-old executive, after maximizing employer-sponsored retirement savings, is considering a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB) rider to provide income beginning at age 67. The contract is invested in a 60/40 allocation of equity and bond subaccounts to comply with rider guidelines.

• The GLWB calculates future income based on a “benefit base” that steps up annually to the highest account value before payouts start.
• If market performance leads to lower account value, the GLWB still provides specified lifetime annual payments—capped at 5 percent of the benefit base.
• Withdrawals exceeding set annual limits proportionately reduce the guarantee.

This approach may provide more predictable income and some participation in market growth, while accepting that total annual fees (approximately 3 percent) will reduce long-term net returns. The executive complements this variable annuity with lower-cost investment funds to control overall portfolio expenses.

Resources for Further Learning

Regulatory Portals

• United States:

  • SEC Investor Bulletin on Variable Annuities: investor.gov
  • FINRA Annuity Resource Center: finra.org
  • NAIC Consumer Guides: naic.org

• United Kingdom:

  • FCA (Financial Conduct Authority) Guidance: fca.org.uk
  • MoneyHelper Retirement Website: moneyhelper.org.uk

Educational Overviews

• FINRA “Know Before You Invest” guides
• Retirement planning resources from university extension programs
• Official variable annuity prospectuses and supplementary documents

Academic Research and Books

• Moshe Milevsky, "Pensionize Your Nest Egg"
• Zvi Bodie & Rachelle Taqqu, "Risk Less and Prosper"
• Wade Pfau, "Safety-First Retirement Planning"

Analytical Tools

• Morningstar variable annuity research and calculators
• Insurer-supplied illustration tools (using appropriate sample inputs)
• Independent financial calculators for modeling long-term retirement withdrawals

Professional and Peer Networks

• Industry news: InvestmentNews, Barron’s
• Online forums with moderated discussion on variable annuity experiences
• Credit agency reports (AM Best, Moody’s, S&P) for insurer financial health checks

FAQs

What is a variable annuity?

A variable annuity is an insurance contract combining market-responsive investment subaccounts with options for structured income and death benefits. Policyholders assume market risk unless specific guarantees are added through contract riders.

How are my funds invested within a variable annuity?

Premiums are allocated across subaccounts that hold equities, bonds, or other asset classes. The contract’s value fluctuates according to these investments’ market performance, unless a fixed or buffered strategy is chosen.

What fees are involved?

Expect to pay mortality & expense (M&E) charges, administrative fees, investment management fees (at the subaccount level), and potential rider costs. Surrender charges may apply to early withdrawals, particularly within the first few years.

Are withdrawals from variable annuities taxed differently than other investments?

Yes. Withdrawals representing investment gains are taxed as ordinary income, not at long-term capital gains rates. Early withdrawals (before age 59½) may incur an additional penalty tax in certain jurisdictions.

When might a variable annuity be appropriate?

Variable annuities may be suitable after other tax-favored accounts have been maximized, if specific needs for longevity protection, structured lifetime income, or supplementary tax deferral exist.

Can I lose money in a variable annuity?

Yes. The contract value is subject to investment losses unless specific riders are purchased to protect principal or provide minimum benefit guarantees.

What is a rider in the context of variable annuities?

A rider is an optional feature that can be added to a variable annuity, such as guaranteed income or enhanced death benefits. Riders increase the contract’s cost and may impose additional requirements or restrictions.

What should I consider before replacing an existing annuity contract?

Exchanging contracts may restart surrender charge schedules and could result in the loss of any legacy contract benefits. A thorough comparison of fee structures, guarantees, and possible impacts is recommended before proceeding.

Conclusion

Variable annuities offer a distinct combination of tax-deferred investment growth and insurance features such as income and death benefit guarantees. These advantages are balanced by higher fees, liquidity restrictions, complex rules, and full market risk exposure unless specific riders are selected. Variable annuities can be a fit for long-term investors who have already maximized other lower-cost retirement savings options and who have well-defined needs for insurance protections. Careful review of contract terms, cost structures, insurer stability, and alignment with individual financial objectives is essential—ideally in consultation with a fiduciary financial professional—before making decisions involving variable annuities.