Variable annuity

Variable annuity

Variable annuities are an appealing alternative for retirement planning because they combine financial growth potential with insurance protection. They are, however, sophisticated financial instruments that must be carefully considered in terms of costs, investment risks, and long-term commitment.  

What is variable annuity? 

An annuity is a type of financial product often offered by insurance firms. It entails making monthly payments to the annuity provider in exchange for future income. A variable annuity is a contract allowing investors to invest in sub-accounts comparable to mutual funds.

The value of an annuity is influenced by several factors, including the annuity contract’s terms and conditions, the payment amount, the duration of the annuity period, and the interest rates in effect at the time.  

A variable annuity’s value might change depending on a successful outcome of the underlying investments kept in these sub-accounts. In this article, we will look at the characteristics and benefits of variable annuities and how they may help with long-term financial security. 

Understanding variable annuity 

Variable annuities allow consumers to invest their money in various investment alternatives, called sub-accounts or investment portfolios. The value of a variable annuity might change depending on how well the underlying assets perform. These annuities are of several kinds, the most prevalent being deferred and instant annuities. 

• Deferred annuities 

For retirement planning, deferred annuities are popular. They are intended to generate a consistent income source at a later point, usually around retirement. You contribute premiums over time to a deferred annuity, and the cumulative value increases tax-free. Income payments often begin at a future date specified by the annuitant, such as at a particular age or after a given number of years. 

• Immediate annuities 

As the name implies, immediate annuities begin providing income immediately away. With instant assistance, you pay a lump amount to the insurance provider and directly get recurring income payments. This can be advantageous for people who wish to quickly turn a large payment, such as an inheritance or retirement asset, into a guaranteed income stream. 

Due to the withdrawal restrictions, variable annuities should be considered long-term investments. During the accumulation period, they typically allow one withdrawal each year. However, if you withdraw within the contract’s surrender period, which can last up to 10 years, you will usually be required to pay a surrender fee.3 Withdrawals before the age of 59 will result in a 10% tax penalty, as with most retirement account alternatives 

Working of variable annuity 

Variable annuities are often divided into two separate phases 

• Accumulation phase 

During this phase, you make purchase payments that can be invested in various ways. For example, you may allocate 40% of your purchase payments to a bond fund, 40% to a stock fund in the US, and 20% to an international stock fund. The money you’ve set aside for each mutual fund investment choice will grow or shrink over time, depending on how well the fund performs.  

Furthermore, variable annuities sometimes allow you to direct a part of your purchase payments to a fixed account. Unlike a mutual fund, a fixed account pays a fixed interest rate. The insurance company may periodically change this interest rate, although it generally gives a guaranteed minimum (e.g., 3% per year).  

You pick how your assets will be invested among sub-accounts, considering the level of diversity and aggressiveness you like. You can put a portion of your funds in a fixed account that gives a guaranteed minimum rate of return with some variable annuities. 

You determine and manage how your assets will be distributed across sub-accounts, considering your preferred level of diversification and aggressiveness. With certain variable annuities, you can invest a part of your funds in a fixed account that provides a guaranteed minimum rate of return.  

• Payout phase 

You can opt to receive your purchase payments plus investment income and profits (if any) as a lump-sum payment at the start of the payout phase, or you can choose to receive them in regular intervals (usually monthly). 

If you select to receive payments in a stream, you may have several options for how long the payments will run. Most annuity contracts allow you to pick whether your annuity payments will run for a specified term (such as 20 years) or an infinite duration (such as your lifespan, the entire lifespan of you and your spouse, or the lifespan of another beneficiary).  

During the payout period, your annuity contract may provide you with the choice of receiving set payments or payments that fluctuate depending on the success of the investment in mutual funds alternatives. 

The amount of each periodic payment will be determined in part by the period you choose for receiving payments. You should be aware that certain annuities do not enable you to remove funds from your account after you begin receiving monthly annuity payments. Furthermore, some annuity contracts are designed as immediate annuities, which means there is no accumulation period, and you will start receiving annuity payments immediately after purchasing the annuity. 

Pros of variable annuity 

• Probable inflation hedge 

If your portfolio does well in the market, you may see a significant boost in your dividends. This will allow you to keep up with inflation better. 

• Initial investment protection 

Ideally, the annuity firm would provide you with the rights to your invested funds even if your portfolio performs poorly and you do not make any interest. 

• Death benefit 

The annuity company will compensate your nominee or beneficiary if you die before receiving payments from your variable annuity plan. 

• Lifetime payouts 

With such plans, you can receive income for the rest of your life, even if your principal investment is exhausted. You may, however, be required to pay. 

Cons of variable annuity 

• No assurance of a return 

Variable annuities, unlike fixed annuities, do not promise that you will make profits or have fixed interest on your investment. If your portfolio performs poorly, the value of your annuity will be affected. 

• Complexity 

Variable annuities are frequently challenging to comprehend. Many investors need help acquiring the concept of its specific requirements. Other forms of annuities are more straightforward.  

• Surrender fee 

If you remove the entire amount or a portion of the money from your annuity before the contract allows, you must pay a withdrawal or surrender fee.  

Example of variable annuity 

Assume a person wishes to invest US$10,000 in a variable annuity through an insurance firm. In this situation, the firm will present the investor with plans/strategies for investing the client’s money. The investor must choose the plan to determine the value based on the fund’s risk tolerance. As it is a variable annuity plan, the value of the investment may fluctuate daily. Some plans may allocate 70% of their money to stock and 30% to debt, while others may allocate 50% to equity, 30% to debt, and 20% to mutual funds. 

Frequently Asked Questions