What is a Variable Annuity?

A variable annuity is a contract sold by an insurance company. The contract provides the holder with future payments based on the performance of the contract's underlying securities. The insurer guarantees a minimum payment, but the rate of return on the underlying securities may vary. The performance of these securities, usually mutual funds, dictates the size of the eventual annuity payment.

Example of a Variable Annuity

Let's assume you put $300,000 into an annuity at age 60 and the insurance company offers to pay you $1,000 per month for the rest of your life.

$300,000 / $1,000 = 300 months
300 months / 12 = 25 years to recover investment

According to our math, you will have to live until age 85 to break even on the investment, and if you live past 85 the insurance company must continue making payments.

To invest in a variable annuity, the buyer makes an investment with the insurer and allocates this money according to a menu of mutual funds allowed by the contract. Some insurance companies also offer asset-allocation funds, which automatically allocate the money in a range of stocks, bonds, treasuries and other investments. The contract grows tax-deferred until the buyer chooses to receive payments ('annuitizes the contract'). Unlike investors who directly own mutual funds, annuity holders may switch in and out of funds and receive year-end distributions from those funds on a tax-deferred basis until the contract is annuitized.

It is important to know that buyers cannot begin receiving annuity payments before age 59 1/2 without paying a 10% federal tax penalty. When payments begin, the contract's investment gains are taxed at the buyer's ordinary income tax rate. Some insurers allow buyers to make small emergency withdrawals without penalty. In some circumstances, buyers may also exchange an annuity tax-free for another annuity with a different insurance company, which is known as a 1035 Exchange and is governed by Section 1035 of the Internal Revenue Code.

Why do Variable Annuities matter?

Unlike some other tax-deferred retirement vehicles, there are no annual size restrictions on annuity purchases. Additionally, the insurance feature of a variable annuity guarantees that an annuity's owner and/or named beneficiaries will receive the greater of the full amount of the original investment or the account value at the time of the buyer's death, net of withdrawals. note that heirs must pay ordinary income tax on the annuity's capital gains. In some states, variable annuities are also a way to shelter assets from creditors.

Variable annuities are somewhat controversial because of their fee structures and the financial incentives given to some sellers of annuities. Fees associated with variable annuities can include commissions to the seller, underwriting fees, management fees, annual fees, application fees, administrative fees, charges for special add-on benefits, annual mortality fees and expense-risk charges. An annuity's underlying mutual funds also generally carry fees. In addition, surrender charges typically apply to the first several years of a contract's life and serve as a penalty for making withdrawals before a specified period. Exchanging variable annuities may expose the buyer to new fees as well.

National Association of Securities Dealers rules require brokers and insurance agents to recommend the purchase or exchange of an annuity contract only after informing a potential buyer about the pros and cons of the investment and only if the investment is in the potential buyer's best interest after evaluating his or her personal financial needs.